Comparing Social Security to a Real Retirement Plan

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Social Security was started during the Great Depression in the United States as a way to keep the elderly from being desparately poor. Retirement really wasn’t a thing back then where most people worked until they no longer could because their health had deteriorated and they were close to death. At that point, those who had adult children might rely on them for the remaining months or years of their lives. Those who didn’t were truly in bad shape. Hence, the need for a system like Social Security.

The idea was to provide a minimal amount of income to everyone in their old age. Because most people didn’t retire until they were a year or two away from the grave, the amount of time one would be collecting wasn’t long. It also wasn’t supposed to fully fund your retirement. It was just supposed to be something to keep you from starving, not fund a 30-year retirement and have cost of living increases. This is why it is a mistake to look at it as some people do today where it is to fund most or all of a long retirement. It isn’t a real retirement plan, just a band-aid.

At least in the beginning the price was right. When it started the cost was very low – just a couple percent of your pay, split between you and your employer – but that amount has increased over the years. Each time the system has started to run out of money, Congress gets together to “fix Social Security” by increasing the payroll taxes used to pay for it. At this point it consumes 12.4% of your pay or about fourty-four day’s wages, which is more than the 10% some of the best savers contribute to their 401K or IRA. And that’s what’s really frustrating: If Social Security were managed like a real retirement plan, you wouldn’t need to fund a separate plan. But it isn’t, so people need to put money into another plan as well, putting away 22% or more of their income for retirement instead of the 10% that would be needed if Social Security were eliminated or privatized into a real retirement plan.

Today we’ll look at exectly what Social Security is and how it compares to a legitimate retirement account. We’ll show that it is a poorly designed system at best and a Ponzi scheme at worse. We’ll finally present a painless way we could transition from Social Security to a real retirement plan.

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How Social Security works

Social Security is a pay-as-you-go system where money from new “investors” is used to make payments to older investors, creating the appearance of a return on one’s money. People who are working today have money taken from their paychecks that goes into the Social Security system, then people who are retired have money sent to them from the system each month. In the beginning there were a lot more people working than were retired, so there was extra money left over after everyone who was collecting benefits was paid. That money was sent to the Treasury in exchange for Treasury bonds. So the extra money was “invested” in Treasury bonds, then was free to be spent by Congress like other taxes that were collected. On the books the bonds pay interest to the Social Security system, so an “IOU” is kept of how much the Treasury owes the Social Security system.

Within the last couple of decades, the percentage of people working has declined relative to the percentage of people retired and drawing Social Security. As a result, the system no longer pulls in more money than it pays out, meaning it is drawing on those “IOUs” built up over the years and is selling back its Treasury bonds. The trustee for Social Security has indicated that the system will run out of that extra savings in a few years. At that point, benefits would need to be reduced by about 30%, Social Security taxes would need to be increased, or money would need to be taken from the Treasury since the amount of money going in from workers through payroll taxes (Social Security taxes) is only about 70% of what is going out to retirees. It could even get more dire than that since the Treasury will only be able to pay back the Treasury bonds if they can collect taxes to cover them or borrow from others by issuing new Treasury bonds. If those sources run out, for example if interest rates went up rapidly and the interest the government is paying on the debt became unsustainable, Social Security would have difficulty selling those bonds back. Given the size of our national debt, this has become a real issue.

How Social Security is like a Ponzi Scheme

In a Ponzi scheme, money from new “investors” is used to make payments to earlier investors, creating the appearance of a large return. An initial investor might pay in $100,000 and then be paid $130,000 in a few months. He would then tell his friends that he was making returns of 100% per year or more in the investment plan, so they would invest. The friends would get large payouts as well, so they would tell others and the fund would grow.

The money is never invested in the scheme, so all of the money the investors receive that they are told is a return from whatever the funds are supposedly invested in comes from the money being sent in by later investors. The people running the system would lie to investors, saying that the oversized returns investors were getting was due to some great, secret investment to which only a few special people get access. Because the early investors tell about the great returns they got and how the people running the funds have a secret method and are uniquely skilled, the later investors think they’ll see the same sort of returns. The organizers of the scheme would also be siphoning off money for themselves.

Because such schemes cater to both greed and people’s desire to be part of something exclusive, they are often able to find investors for a few years. At some point, however, there would no longer be enough new investors to cover both the payouts to the earlier investors and the large “returns” being generated for them. At that point the whole thing would collapse and those invested at the time would lose all of their money. The people running the scheme would grab whatever they could just before that happened and run off to avoid the authorities.

Social Security works exactly the same way with the exception that the returns are dismal and participation is compulsary. Just as with a Ponzi scheme, the returns paid to early “investors” come from later “investors” since those working now and being forced through payroll taxes to put money into the system are paying for those who worked before and have since retired. Those receiving benefits think they are being paid from money that they paid in before that was somehow saved and invested or from the government. They largely don’t realize that they’re being paid by the others currently working and that without them, there would be no benefits. There is no savings or investment, so the system needs new people to keep going. If the new people ever decrease in numbers too much, or if they decide they aren’t going to participate, the system would be exposed for what it is and benefits drop or the whole system would even collapse.

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Also like a Ponzi scheme, those running Social Security – Congress – have regularly siphoned off money from the system that they used for other things. For the first several decades of the program’s life until about 2020 the system was taking in more money than was being collected since there were a lot more workers than retirees since people didn’t live long after retirement. Because of the longer life expectencies and because there was a big glut of people born in the babyboom generation that would start to overwhelm the system in the mid-2000s, in the 1980s taxes were raised well above what was needed to sustain the program at the time. The idea when Social Security taxes were raised was to collect more and save it up so money would be available for the larger payout needed as the Boomers retired, but the government spent rather than saved the excess money.

So, now we’re seeing the underfunding expected and for which the taxes were raised to prevent rather than a big pile of cash that could have been used to fund Boomer retirements. As we start to see the money collected underrun the payout so that there isn’t enough money to cover benefits, no doubt Congress will propose that we raise Social Security taxes again to cover the deficit and keep the Ponzi scheme going. They like people thinking that the government is taking care of them and being able to threaten that their opponents will take their Social Security benefits away if they are elected. It is especially powerful politically since people feel like they “earned” the payouts, so both sides of the political spectrum will fight to protect the program. That is why articles such as this are needed to educate people on what the system really is and how things could be so much better.

What does a “real” retirement plan look like?

A real retirement plan like an IRA or 401k works because the money received from each worker is actually saved and invested. Not only are the dollars put away stored, they are allowed to grow during the 40 plus years the worker is still at work by being put into companies that then grow and become more valuable. The dollars invested generate more dollars, some of which are then added to the retirement account. When the worker is ready to retire, the money he set aside and invested is there waiting, ear-marked for him. He doesn’t need to rely on anyone else working and putting in money for his retirement to receive payouts because he is using the wealth he created.

This growth in his funds is key to making the “returns” generated by private accounts far better than those provided by Social Security. If you put about 10% of your income away in a private retirement account and invest it in a diversified set of common stocks, you’ll easily generate enough money over a working career to replace your working income. In fact, if you have a middleclass income you’ll be able to generate what would have been considered a wealthy income in retirement, esepcially without the costs of working included. With Social Security you contribute 12.4%, but you only cover a small portion of your income. Plus, the value of your Social Security “account” is fully set by how long you live after retirement. When you die, your heirs receive only a $500 death benefit from Social Security. You might work your whole life, but then die at 64 and have nothing to pass on to your children with Social Security. With a true retirement account, you can pass on all of the money in the plan even if you die before you can retire, which would be a significant amount in the millions of dollars. Even after funding a retirement for a number of years you’re likely to have funds to pass on or give to a favorite charity when you die.

A common argument against using private accounts is that money would be invested in stocks, which are “risky,” and therefore it is better to have a plan backed by the Federal government and that is “safe.” We’ve already shown that the “safety” provided by the government is an illusion since it all collapses if people stop contributing and if the government gets into financial trouble as they seem to be trying their best to do. A diversified set of stocks held over a long time also really isn’t risky as we show elsewhere on this site and as detailed in any number of college investment books. Really, however, part of the funding for benefits in the private accounts comes from the same source as Social Security. When the money in these personal accounts is invested in stocks, as most is, it is a little like the Social Security system in that some of the money being invested by new workers when they buy stocks is being pulled out by retired workers as they sell the same stocks. Unlike Social Security, however, those buying stocks in an IRA or 401k do hold something of value – ownership in companies and access to part of the income they generate – that grows in value with time beyond the money being sent in by other workers. Those leary of privatizing Social Security will say that the stock market is too dangerous and it is better to have a pay-as-you-go system like Social Security, but at least part of the benefits retirees receive is funded the same way.

And think about what would need to happen for all stocks to fail and private accounts invested in stocks to become worthless. The entire economy would need to stop where everyone stopped working and every company failed. There would be no goods or services and most people would starve or be killed in riots. And if everyone stopped working and the economy collapsed, while it is true to there would be no money in private retirement accounts, there would also be no money available for the Social Security system either. And even if retirees had money available to them in such a scenario through some miracle or if the government just started printing money and handing it out, if everyone stopped working there would be nothing available to buy with the money. If the whole economy collapses, everyone will be left living off whatever they and their families could produce themselves. Whether we have private accounts or Social Security won’t matter.

Truly fixing Social Security

So to truly fix Social Security, we’d need to transition it from the Ponzi scheme to a real plan with real investments and where each investor had a personal, assigned account. The issue is that if workers simply started contributing to personal accounts today, there would be no money for those who are retired already to receive benefits since they are on a pay-as-you-go system dependent on new money coming in from today’s workers. This could be solved in a relatively painless manner, however.

The way to accomplish this would be to make a deal with people working today. Allow each person to choose another person who would be able to contribute to a private account in exchange for the first person giving up all Social Security benefits while still paying the payroll taxes until retirement. Parents who have also funded a regular retirement plan might choose a child to free from the system, for example, figuring that the amount of money they’d get from Social Security wouldn’t be much if they saw anything, so they’d rather free their child from the system than collect meager benefits from a system that might collapse anyway. A mother and father could exempt two children this way. Because there are more people paying in than receiving benefits, each person that chooses to give up their benefits for one other person not needing to contribute anymore would make the system stronger for those who chose to remain in it, so everybody wins.

If that were not enough people taken out of the benefits pool to transition the system, the answer might be a hybrid system where new workers put some of their money into private accounts while still contributing a portion to Social Security even though they would never get a full payout from the system. Because the rates of return from Social Security are so bad, just contributing a little to a real plan would make up for a significant cut in what is received from the Social Security system. Each year new workers entering the workforce would contribute progressively lower percentages to Social Security until everyone was fully out. Congress could also pay for some of the benefits from the Treasury to help the transition along. The system could also become a simple charity program where those who don’t need the money see their benefits cut or eliminated to provide more money for those who saved nothing and would starve without the payouts.

Note there would really be nothing wrong ethically with current workers simply voting in representatives who would end the system immediately and allow them to fund personal accounts instead. Today’s workers never voted for the people who created Social Securiity and did not agree to the deal to fund others’ retirements in the hopes that theirs would be funded by others not yet born when they retire. Their money is being taken without their permission, so they have no ethical obligation to continue the system. If they stay in the system for several years and don’t try to change it, at that point they are agreeing to it with its many disadvantages, including the possibility that the next generation may choose to end the system and those who decided to stay in it now would not receive anything. But if today’s workers object from the start and end it tomorrow, it isn’t their fault that others who signed onto that deal in the last 40 years would be left hanging.

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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.

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