What's wrong with entitlements? We pay for them, don't we?

A friend and reader asked me those questions the other day.  Pretty good questions, aren't they?

Entitlements loom large in the political disputes over Federal government spending.  Mostly, the word "entitlements" seems to focus on two programs in particular:  Social Security and Medicare.  Even if you choose to define the word to include other social assistance programs, Social Security and Medicare are the two big gorillas of entitlements.

A simple, straight-forward answer to my friend's questions would be:  There's nothing wrong with these entitlements, as long as we pay for them, and as long as what we pay in is managed properly.  And, yes, it's pretty easy to see that each of us, individually and collectively, pays for those programs by way of taxes on earned income.

But since we're talking politics here, few things about the future of Social Security and Medicare are straight-forward.  However, I'm going to do my best to simplify and clarify by describing a few things that are not commonly heard, either in the press or in the political disputes.

Social Security -- an overview and some helpful hints

Let's be clear about something:  there is no coherent rational argument to say that these programs are fiscal basket cases and should be terminated for the good of the country.  That doesn't mean that they are perfect; what it does mean is that both programs are worthy and beneficial.

Should these entitlement programs be run so that each of us will get back from them at least as much as we have put in?  Yes, of course they should be run that way.  That's the way they are being run right now--as long as a person lives long enough--and there's no compelling fiscal reason to change that.

Do these programs need some changes to keep them solvent into the future?  Yes, I think so.  Does future solvency mean that benefits must be reduced?  Maybe so, maybe not so; there's no reason to assume that reducing benefits is the only way to assure future solvency.  Anybody who maintains that benefits reduction is the only way to assure solvency is just engaging in political theater.

Let's look at Social Security.  (I'm not going to get into Medicare right now; maybe another time.)  Every year, the Social Security tax contributions are split between deductions from an employee's paycheck, and contributions by the employer.  (Self-employed people pay the full amount that is the combination of the contributions by both the employee and the employer.)  These taxes stop being levied once the individual's gross income reaches a certain level for the year, currently $113,700.  You can see all the details about the rates, plus lots of retirement calculators and other information on the Social Security Administration's web site.

Information on the exact taxation rates for both Medicare and Social Security is currently available on this Social Security Administration web page.

The various calculators and data retrieval tools make it pretty easy for a person to find out how much he or she has paid in to Social Security (and Medicare, too), as well as obtain estimates for expected Social Security payments at various ages.

Social Security pays back what you put in -- an example

With that information in hand, all it takes is a little simple mathematics to get an idea of how much Social Security will return to an individual over time, and how that compares to the individual's Social Security contributions.

Take me, for example.  If I were to start taking Social Security benefits at age 62, I would need eleven years to have those payments equal the amount that I have already contributed to the program.  If I wait on starting benefits until age 70, then from that point on it would require a little over six years to reach that same milestone.

Which begs at least one question:  How much longer can I expect to live?

Well, accidents aside, the mortality information that I am familiar with gives me a good feeling that I can wait until age 70 to start taking Social Security benefits if I should so choose.

Of course, all of this ignores the time value of money, and the obvious fact that a dollar saved some years ago--and properly managed for investment--should be worth a whole lot more than one dollar today or at some point in the future.

But--and if you remember only one thing from reading this post, make it this one here--Social Security was never designed to be a savings account or investment program, so the concept of a time value of money, or of investment return, just doesn't really apply to it.  Social Security was designed to be pay-as-you-go, in which a portion of the earnings of the younger, more employed and more employable part of the population is transferred to the older, less employed and less employable part of the population.

Nonetheless, some people persist in asking, Wouldn't I do better with my money if I could keep it and invest it myself?

Who would have thought bureaucrats could do this good a job?

Because of the fundamental design of Social Security, the only answer to the self-investment question is, Well, maybe, and only if you are very lucky and well-disciplined; and, on top of that, you would need to reject the established need for Social Security, which, as described above, is that the older, less employed and less employable part of the population has a demonstrated need for this kind of income transfer.

Just how good a job does the Social Security Administration do in managing all that money?

Social Security is more than just a pension payment program -- it also provides disability and survivor's benefits.  As I said earlier, it was never set up as a savings and/or investment program.

However, let's take the growth of my estimated benefits between the ages of 62 and 70 and compare that with some historical investment results.

In my case--and I believe this to be applicable to everybody--my Social Security benefits at age 70 will pencil out to be about 75% greater than they will be at age 62.  If we look at this as an investment decision, then that's a pretty good compounded rate of return of about 7% or 8% annually.

For comparison, consider the mutual fund called The Growth Fund of America (from American Funds).  Its current price of about $43/share is 47% greater than was its closing price on October 14, 2005; that is to say, over eight years, money invested with this fund would have grown by 47% (not including dividends, distributions, and any reinvestment of these monies).  Admittedly, this is an imperfect comparison for numerous reasons.  But it shows that the Social Security Administration does a good job of managing our money.

How about diverting all that Social Security money into individual 401(k)s (and similar programs) instead?

The obvious answer is that any given worker is better off with both programs in place -- invest the 401(k) wisely and carefully, and depend upon Social Security both for providing supplemental retirement income, and for providing assistance for unexpected or unknowable events (disability payments, survivor's benefits).

Math, actuarial assumptions, and other gobbledy-gook

So, why does Social Security say that benefits will have to be reduced by about one-quarter beginning in 2033?

That projection is based on a grab-bag of actuarial and demographic assumptions, all of it put together and massaged with mathematics that I do not understand and probably couldn't explain here even if I did understand them.  But consider that the design of Social Security--both for benefits and for revenues--assumed that the nation's working-age population would be much larger than it now is in relation to the number of retirees, and also that the income subject to Social Security taxation would have a much broader base than it now does.

The last time Social Security tax rates were increased was in 1983.  That was done when the math wizards showed Congress that the impending retirement of the so-called "Baby Boom Generation" would drive the need for the additional funding.

As a fix to the program, that means it will be good for a half century.  That's a lot of years, and so it counts as a pretty darn good piece of legislation and behind-the-scenes technical work.

Social Security, as mentioned above, is not really a savings program, but more of a pay-as-you-go program.  As such, its design requires a certain ratio of paid workers to retirees in order to maintain the benefit payments.  Sometime around 2033 we will fall below that target ratio; at least, according to current demographic assumptions.

Those assumptions might have to be changed--hopefully for the better--if the recent uptick in the nation's fertility rate results in an unexpectedly larger workforce in twenty years or so.  Another potential influence could be an increase in the number of immigrants who could become gainfully employed (and taxed) as a result of an improved national immigration policy.

You've probably heard something about the demographics of the thing, so let's move on to the other design point mentioned above.  This is something that I have not yet seen widely-discussed; perhaps that implies that what I'm about to say is wildly off base, but it might also mean that it's one of those things that just hasn't gotten a lot of attention yet even though it deserves to have the attention.

Another downside of income inequity--read about it here first

America has a real problem with inequities in its income distribution.  For example, recent press has focused on the fact that corporate CEO's now earn about 350 times what the typical corporate employee earns.  By comparison, thirty years ago the multiplier was about 42 times.  That's a huge change, especially when we consider that there's a much larger group than just CEO's who have benefited from the tendency of wealth and income to accumulate much more with the top couple percent of the population than with the vast majority of Americans.

How did the income distribution look at the time of the design of Social Security?

That was in the mid-1930s.  At that time, the share of national income that went to the top 1% was not only significantly lower than it is now--something like 15% as compared to the current 25% or so--it was declining.  Eventually, that chart over time flattened-out with that share bouncing around the 10% figure, where it stayed for decades until beginning its inexorable rise in the early 1980s.

What this means is that a system that was designed to obtain revenues through taxation of a population where the income distribution was flatter and broader than it is now--and will be for the foreseeable future--must now be made to work in an environment where a much bigger piece of that income pie is beyond reach of the taxation authority.

In addition to the adverse effects of income inequality, we are also now in an environment--never envisioned during the design of Social Security--where significant and growing amounts of income are from the relatively elite sources of stock-holder dividends and private equity earnings.

It all adds up to an environment that favors the most fortunate at the expense of the less fortunate.

If you think this sounds like another "tax the rich" scheme, you would be right, because that's where the money is.  And, frankly, Social Security was designed to obtain its pay-as-you-go revenues from the broadest possible base of available earned monies.

There are probably lots of possible ways to improve Social Security's fiscal outlook through minimally-disruptive taxes.  One example that comes to mind is to levy the Social Security tax on dividend income, perhaps on some kind of graduated basis.  Doing away with the maximum income that is subject to the tax is another.  Any of us can probably think of additional ideas.

Maintaining Social Security's solvency through benefit reduction ought to be the choice of last resort.  Updating the program to make it current with the new realities of 21st century sources of income ought to be given first consideration.