Why Investing in Index Funds Would Be Far Safer than the Current Social Security System

Whenever the idea of creating private accounts and replacing the current Social Security system is floated, there is always someone there to talk about how risky it would be to bet everyone’s retirement on the stock market.  After all, look what happened in 2008, right?  The security of the existing system, however, is a mirage just as were the stellar investment returns of the Madoff clients before the Ponzi scheme folded.

In fact, going to private accounts with a limited set of index fund investments would be closer to what Social Security was originally envisioned to be – a system where current workers would help provide benefits for current retirees with the expectation that later workers would provide funds for their retirements.  It would also address a critical shortcoming of the existing system.  That is, no one asked what would happen if the revenues collected exceeded those required by current retirees due to a large number of people in a certain age group of the population, as was the case through the 1980’s and 1990’s.  Apparently the answer was that the Government would place the funds in the general treasury and spend them as they saw fit.

You see, unlike a standard pension plan where money is invested, the US Government “invests” excess monies that are collected in US Treasury bonds.  While this would be a fine investment for an outside group, for the US Government this is like a wife investing for her retirement by giving part of here pay to her husband who then spends the money and gives her an IOU that pays interest.  When she gets ready to retire, this would only work if he has the money to pay the IOUs at that time.  Given that the US Government is $17T in debt, runs a large budget deficit each year, and has trillions of dollars more in obligations that will be coming due such as Medicare, this does not seem likely.  The Social Security Trustee has been warning for years that the ability for the US Government to meet its obligations and pay full Social Security benefits is in great peril.

Even if the Government is somehow able to pay full benefits, the return are dismally low – far less than what could have been made by an investor in a set of index funds over the period.  After inflation, a return of less that 1% is realized from Social Security, compared with 5-8% from index funds.  This is the difference between $1000 per month and $10,000 per month in income during retirement.  That $1000 per month also assumes that the individual lives to collect.  If one dies young or as a worst case, right at retirement age, he can receive nothing.  This means that the choice is really between possibly having a bad return through the stock market or ensuring oneself of a dismal return through Social Security.

Investing privately in index funds would actually have the wealth transfer effect envisioned in Social Security from the current generation of workers to the current generation of retirees.  This is because current workers would be buying into index funds, which in turn would be buying the shares of stocks that individuals entering retirement would be selling.  If this selling were done over a period of years rather than all at once, it is very likely that the price of the stocks in those indices, in general, would not decline much at all due to the exodus of current retirees.  This would assume, of course, that people retiring today were invested in those index funds, which unfortunately is not the case.  If today’s workers started investing privately, however, we could achieve such a situation in ten to twenty years.

So how to transition now that we’re in the mess?  Unfortunately the attempt to move to private accounts under President George W Bush failed (and I’ll never forget the cheers from the Democratic side of the aisle when he mentioned the failure at a State of the Union Speech).  If we had, we could have had a large portion of today’s retirees, who form the bulge in the Baby Boom portion of the population’s demographics, invest their contributions during the last eight years before they retired.  The would then have had about eight year’s worth of retirement benefits (Social Security payments at the current rates) in index funds now. This would have been enough to pay the equivalent of the benefits they would have received through the existing Social Security system through their retirements, or at least a good portion thereof.

Many say that we cannot change now because there are so many people retired or going into retirement who paid in for all of those years who are entitled to the benefits they were promised.  Of course, this argument assumes those entering the work force today are obligated by agreements those who are retired now made with elected officials who were out of office before today’s workforce was even born.  In the least, the current generation of retirees didn’t do anything to change the system, or vote in people who would change the system.

Still, we obviously don’t want frail widows and widowers out on the streets.  To make a change, everyone will need to give a little for the greater good.  Current retirees who don’t need the money for basic needs (food and shelter) will need to see their benefits cut.  Those nearing retirement ( age 60 and older) may need to see the age at which they can collect Social Security raised in exchange for the ability to put their contributions into private savings accounts for the next several years.  Those in their forties and fifties may need to give up what they have contributed so far in exchange for being able to invest maybe half of their contributions in private accounts.  And those in their 20s and 30s may need to contribute a large portion of their contributions – maybe 75%, into the current system to pay for existing retirees for a period of ten to fifteen years in exchange for the ability to invest the other 25% privately and the ability to invest everything after the 10-15 year period.

Transition won’t be easy, but the effect on retirees in 20-30 years will be worth the near-term pain.  Americans have always sacrificed for their children and grandchildren.  Is it right to be obligating those being born today before they even take their first breaths?

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.


  1. Fixing social security is easy and it comes down to the simple understanding that the system CANNOT support the exponential growth of beneficiaries in the future. So that means the only way to make the system work is to decrease the amount of people collecting. The most fair way to do so is to let people OPT OUT by their own free will. Some may not know that many government employees are already exempt to paying the tax due to contributions to other retirement plans. This is simply not fair if an intelligent investor would like to opt out, but cannot.

    The way I would propose it, is to take the current 6.2% employer and 6.2% employee tax and if someone opts out, they are permanently opted out and the employee portion of the tax would fall to 1.2%, while keeping the employer portion the same regardless (this is necessary to eliminate employer bias against employees as well as making self-employed people unable to abuse it.) So the employee willingly gives up their future social security benefit and in return gains a 5% income boost WHILE still contributing to the social security trust, thus making it viable in the future.

    Q: What if an employee changes their mind?
    A: Good question, the system would have to be set up to either not allow changing of minds after a certain point, or if they do change their mind, require repayment of previous SS taxes, plus interest. However repayment of these amounts would be irresponsible and the employee will probably realize they are better off with their initial decision to opt out.

    Q: What should I do with my additional 5% in pay?
    A: If you have to ask that question, then it may not be for you, however I read an article somewhere that says investing in simple index funds is a good option 😉

    Q: What if everyone just decides to opt out?
    A: Well hopefully people who have contributed for several years don’t just give up their SS claims for an extra 5% income for a few years, but it is certainly an appealing option for young workers. Eventually, most workers may be opted out and the system will go on to help disabled people and the taxes could be reduced further at that point (at least I would hope that is the goal).

    Anyway, hope you like this idea, it really is the only 100% fair way to fix social security and it also lowers taxes *GASP* and thus also helps to stimulate the economy (lets be honest not everyone will save the extra 5%, I mean most people who opt out will hopefully be fine without it saved anyway).

    • The issue with allowing people to opt out is that you’ll have destitute seniors who thought they would simply work forever until they became too ill and frail to continue. While there are many people who do take care of themselves, there are many other who do not. Witness the number of people who decide to cash in their 401k plans when they finally build up $50k or so to start a business or send a kid to college despite the 40% tax. I don’t like forcing people to do things, but forcing people to save for retirement is good for society in general and good for the individual and unfortunately, many wouldn’t without the requirement. I’d just like to make it so that they don’t need to save for retirement twice.

Comments appreciated! What are your thoughts? Questions?

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