Saturday, February 26, 2011

Fixing Social Security - The Private Lockbox

I wouldn't go so far as to say Social Security is broken, but it sure could use a few improvements.  Some say that funds collected for Social Security should be stored in a lockbox to ensure that people receive payments when they retire.  Others say that funds collected should be invested in risky private ventures so as to increase the rate of return.  What I propose is a mixture of these two ideas: the Private Lockbox.


Let's do a simple test.  For this exercise, all you need is the latest Social Security Statement the government sent you.  (It's usually a four page document with green lines on it.  It says "Your Social Security Statement" at the top.)

I've created this spreadsheet (created on a Mac - no viruses) that will allow you to type in your information and see how well Social Security will perform for you.  The spreadsheet presents an alternative scenario where: instead of your money going to the government, it is placed into an interest bearing account.  When you retire, the account pays your benefits.  This alternative scenario allows you to compare.  If you run out of money before you die, then Social Security as it stands now is the better deal for you.  If you don't run out of money, then you would be better off investing your money yourself.

Here's how to fill in the spreadsheet.  (Note that this spreadsheet isn't meant to be printed out.  If you really want to print, you will have to setup up the print layout yourself.)
  • In cell B1, type the year you were born.  (Don't lie - no one's going to see this but you.)  
  • In cell B2, type how old you want to be when you retire.  You only have three choices: 62, 67, or 70.
  • In cells F3 through F5, type the promised Social Security monthly benefits as spelled out at the very top of page 2 of your statement (Retirement section).  You should see different benefits for ages 62, 67, and 70.
  • In cells C9 and down, type the "Your Taxed Social Security Earnings" numbers from the very top of page 3 of your statement.  Copy those numbers exactly as they appear, and be sure to match up your wages with the correct year.  The spreadsheet starts at age 14.  If you worked before then, just leave out those early years and fill in your wages starting with the year you turned 14.
  • In cell J1, type the wages you made in the last year listed on your statement.  This replicates their assumption that you keep making your last year's wages until you retire.
  • Finally, check cells C9 and down again.  It should show that your last year's wages continue until you retire.  If it looks messed up, copy and paste the correct numbers and/or just type those wages until it looks right.
Now that you have the spreadsheet filled out, are you ready to have fun?  Let's start off with 0% interest.  In cell B4, type 0%.  And for retirement age, let's type 67 in cell B2.  With 0% interest, you simply put money in the bank.  It doesn't earn any interest, and you start taking the money out when you retire.  Column F shows the balance in your savings account at the end of each year.  When that goes negative, you've run out of money.

In the example that comes with the spreadsheet, this poor person (we'll call him Bob) runs out of cash at age 80.  When I type in my personal numbers, I run out at age 79.  I suspect that you will find in your situation that you would run out of cash about the same time.

I don't know about you, but I intend to live older than 80 years.  I wouldn't want to run out of savings.  At 0% interest, Social Security is the better deal.

Now let's change the interest rate in cell B4 to 1%.  This is a decent interest rate.  When do we run out of money?  Bob runs out at age 83.  I also run out at age 83.  This is probably right at the life expectancy of someone who makes it to 67 years old.  Though I want to live beyond 83, this looks like a breaking even point.

How about 2% interest?  Bob runs out at age 89 and so do I.  This is starting to push it.  I don't want to get too wrinkly.  The savings account is starting to look better than Social Security, but not by too much.

Now let's try 3% interest.  Bob and I run out at age 103.  There's no way I'm living that long!  I'd definitely choose the savings account alternative.

Something funny happens at 4% interest.  Go ahead and type that into cell B4.  After Bob and I retire, our savings account is GOING UP.  This is because the interest alone on our savings is enough to support the benefit payments.  We will never run out of money!  Do I think I could find a safe long-term investment that can return 4%?  Um ... yeah!  Social Security is left in the dust.  (Watch that some of you comment to me that your personal numbers don't show this.  Just let me know and I'll stand corrected.)

Finally, if you keep in mind that the average long term returns on the stock market are 12%, go ahead and type that number into cell B4, and see what you get.  Bob becomes a multi-millionaire!

From this exercise, I estimate that Social Security's rate of return is somewhere between 1% and 2% (and that may be a little generous).  I don't know about you, but I think I could do much better on my own.

I feel as if the government has forcibly taken a few talents from me (excuse my Bible reference), and have buried them in the ground. If I live long enough, I'll eventually get them back.  But what good will they be?  There's no way I'll be able to live off of my Social Security check alone when I retire, and it feels like I've put so much into it.

Though Social Security promises a steady monthly check, it's my opinion that as it is now, it is an inefficient solution to providing security for our elderly.


There are two main solutions which would work.  #1) Do away with Social Security altogether.  OR #2) Introduce higher returns.

Solution #1 just isn't going to happen.

This leaves Solution #2, which means investing in the private stock market.  That's the only way to get higher returns.  However, this introduces risks.

For example, during times of plenty, Grandpa Sam could be rolling in the Social Security dough from his investments and come out a millionaire.  And then when the next market crash comes (and it will come), Grandma Julia loses all her benefits.  This doesn't seem fair, seeing how they put the same amount of their hard-earned cash into Social Security taxes.

We can have both the security and the high returns by using a plenty/famine approach, much like the story of Joseph and the grain in the Bible.  During seven years of "plenty," Joseph collected grain from all sources.  Then when seven years of "famine" came, he was able to distribute the stored grain (at a profit - no doubt) and help everyone survive.

Likewise, let's say that the stock market earns an average of 12% a year in the long-term.  Let's choose a guaranteed return of 6%.  When the stock market's doing well, the government would store the excess earnings in a very large contingency reserve (a fancy term for lockbox).  When the stock market crashes, the government would dip into the contingency reserve to pay out the same level of benefits.

Could we use a 6% return on what the government takes in Social Security taxes?  Let's look at Bob's situation.  If he retires at 67, he's only going to get $1,250 a month.  That doesn't buy very much.  At 1.5% interest, the savings account scenario runs out of cash at age 85, which is well beyond the life expectancy.  At 6% interest, Bob's benefit can be raised up to $4,700 a month to get the same results.  Now that's something I could live off of when I retire.

If the government could somehow guarantee an 8% return, then Bob could raise his benefit to a whopping $8,500 a month.  Wow!  At 12% (unreasonable and too risky to guarantee), the benefit goes up to $28,600 a month.


This analysis of mine is nowhere near perfect.  There are other concerns I don't consider, such as the idea of government controlling private stocks.  This could be somewhat offset by disallowing voting rights to government entities.

Also, there's the issue of having such a large Social Security contingency reserve while other funds are suffering.  I could see a large temptation to dip into the reserve to fund other projects.  This could be offset by setting an upper limit on the contingency reserve.  If the reserve ever gets tapped out, the excess "excess funds" could be allowed to go to other budgetary needs.

Even if we were to begin now with such a plan, it could take decades to build up the contingency reserve.  If a large market crash happens too soon, the government could be looking at a major loss.  This risk can be easily mitigated by easing into higher returns.  That is,  now we're getting around a 1.5% return.  We can raise that to 2% for a couple of years.  (Everyone's benefits go up.)  If the stock market's doing well, then we can raise it to 3%, and so on until the contingency reserve is sufficiently large to support a 6% return (or whatever the magic number is).

Also, my analysis includes the employer-paid portion of social security taxes.  Not only does this represent the total money that the government collects, but it also represents (in a perfect market) the higher wages the employer would pay if no Social Security taxes were taken out at all.  In actuality, if Social Security were to disappear, your employer probably would not pass on the full 6.2% savings to you, but rather give you a slightly lower raise.

Finally, this proposal does have the added benefit of putting more money into our economy through investing in private businesses.  This has to be a good thing, especially if it produces more jobs and even higher returns.  Sure there would be a lot of fine details to iron out, but I'm sure the fine men and women of Congress could figure it out.  To me it seems a no-brainer that this proposal is the way to go.

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