Sunday, February 28, 2010

Social Security is based on poor business model

Published in The Tennessean, February 28, 2010

Social Security is based on poor business model

by Richard J. Grant

Suppose you decide that you need a vacation, and the price of that vacation just happens to be $5,000. But you don't have enough cash, so you borrow the $5,000 from your retirement account and place an IOU for that amount in your account. Now you can go enjoy your vacation and pay yourself back later – perhaps with interest.

What is the effect of this action? Instead of $5,000 in cash assets, you now have a $5,000 IOU from yourself, as well as a $5,000 liability to yourself. Instead of a $5,000 net-asset position, you have happy vacation memories. Also, you might be pleased that you do not owe the money to a bank: you "owe it to yourself."

If you are happy with this outcome, that is fine. But what does it mean for your future?

If the IOU is still in your account when you retire, what is it worth? Let's pretend you could sell it for $5,000. But you would still owe the buyer $5,000, so you really haven't changed anything except the amount of cash currently available. The cash goes into the same pool from which you will pay back the loan.

To pay yourself back before you retire, you must still save $5,000 and shift it from your bank account into your retirement account. So either way you come out the same: you have chosen to consume $5,000 as a vacation rather than have it available for your retirement. You might just "work harder" to make up the $5,000; but you could have done that anyway.

Now let's look at Social Security. Until recently, the Social Security system was running a surplus of payroll taxes over outlays and put the proceeds into its trust fund. These surpluses were lent to the US government by purchasing special Treasury securities that are not marketable but pay interest and can be redeemed at face value.

As part of the government's general fund, the borrowed funds were spent on the usual multitude of programs, most of which is current consumption. The US government owes this money, now totaling just over $2 trillion, to the Social Security Administration, which happens to be a US government agency. (It owes another $2 trillion to other agencies.)

From the government’s perspective, the situation resembles that of the individual in the example above. The government, through the Social Security Administration, has obligations that it must pay to eligible retirees. To fund these payments it must draw on payroll taxes (from other people) and, now that it is running a deficit, on redemptions of Treasury securities from its trust fund.

When the government is repaying cash to the Social Security system, it must divert that cash from other uses. It must cut spending in other programs, or increase tax revenue to the general fund, or borrow from another source.

Unless something changes, the Social Security trust fund will be exhausted by the year 2037. (This looks good in comparison to Medicare's Hospital Insurance Trust Fund, which will be exhausted by 2017.) It was never intended that Social Security be a true investment fund based on sound investment practices. It is a pay-as-you-go system, much like that used by Bernard Madoff, except that Madoff could not levy a payroll tax to perpetuate his business.

The fate of the Trust Fund is useful to us as a market signal. It shows us that Social Security is based on a poor business model. It is just another welfare program, and its associated taxes add to the income-tax burden on workers.

We know that higher marginal tax rates are associated with lower rates of economic growth. We also know that most of our government spending, far from being a "stimulus," also reduces long-term economic growth. Most regulations cause more harm than good.

Knowing this, we can change. But it does matter which direction we go.

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010