While reading Your Money Ratios, a book I intend to review later this week, I was particularly struck by the chapter on Social Security. Discussions of what will happen with this popular, yet tricky, retirement program continue to animate the national stage here in the US, and even as we speak, new reforms are being rolled out that will tweak, although not completely change, the way that the Social Security system works. Given the importance of this system to most people’s retirement, I thought I should take a closer look at it, and hopefully dispel some of the myths and rumors surrounding it.
What is Social Security?
I think that many Americans have a distorted idea of how exactly Social Security functions, in part due to all the talk of the ‘trust fund’ we’ve heard about, going back to the days of the 2000 election. Many people (including myself, before I started to do so much personal finance reading) have the impression that Social Security works like a national 401(k): you put your money in throughout your life, the US government watches over it and invests it, and when you retire, you end up receiving your own money back, with interest.
That’s not the case. (It can’t be; Ida May Fuller, the first person to start receiving Social Security benefits, did so after paying into the system for only three years, not nearly enough time to build up much of a fund for herself.) Instead, what happens is that most of the money paid into the system by those currently working goes directly to current retirees, covering the benefits they earned while working themselves. When the amount coming in is more than what’s needed to pay the current benefits, the rest is put into the ‘trust fund’, the accounting surplus that is left over and used to pay future beneficiaries.
This structure, with current workers’ contributions being used to pay current retirees’ benefits, has led more than a few commentators to call Social Security a Ponzi scheme, and to hypothesize that, like all other Ponzi schemes, it will eventually collapse. This view ignores a few facts, though, including that the transfer of wealth isn’t hidden from view (or significantly different than most other social welfare programs, possible differences in funding aside) and that, with contributors consisting of every working American and contributions enforced by federal regulations and the threat of jail, it’s highly unlikely that the incoming funding will stop, which is when Ponzi schemes come to an end. (Unless our democratically elected Congress and President vote and sign into law new regulations ending Social Security, but that’s not really the collapse of a Ponzi scheme so much as a new legislative approach.)
A more productive way to view Social Security might be as an annuity, particularly a deferred, fixed, inflation-linked annuity. You pay into the system throughout your working life, building credit with the government, and upon retiring, you start to receive money according to how much you’ve contributed. Live long enough, and you’ll recollect your contributions (and then some, if you’re really long lived); die shortly after retiring (or *knock on wood*, before you have the chance to retire), and you’ll find that you received much less than you contributed. Like an annuity, it’s more of a safety net to make sure you don’t outlive your money than a get-rich investment.
What About That Trust Fund, Then?
Ah, the trust fund, confusing people into thinking that they are paying for their own benefits (rather than paying for their parents and grandparents, and in turn being paid for by their children and grandchildren) for over a decade now (if not longer). The trust fund does serve a useful purpose, that is, ensuring that when the payments due to retirees exceed the income resulting from taxing current workers, a reserve of money exists from which to draw the difference. In fact, the last major overhaul to the Social Security system in 1983 was designed to build up the trust fund for when the baby boomers started to retire, which it did in fact accomplish. (Which is why we’re debating how long the trust fund will last, rather than how much of a deficit the program will develop paying out claims to boomers.)
The problem is what happened to the money in the trust fund. It’s not kept in a giant vault a la Scrooge McDuck, in savings accounts throughout the country, or even invested in the stock market (not for lack of trying on George W. Bush’s part, but that’s another story); instead, the trust fund is invested in special Treasury bonds. In essence, the trust fund loans the money to the federal government’s general fund, where the money is spent on, well, everything the government spends money on. There’s no perfect analogy to individuals, but the closest situation would be if you took money out of your retirement account to pay your monthly bills, with the intention of paying yourself back (with interest) when your financial situation improved. Because of this, more than one commentator has said that the trust fund is actually filled with ‘worthless IOUs’.
That’s not quite true, though; while Treasuries, like all bonds, are IOUs (specifically, ‘I owe you X amount of money, with Y amount of interest, payable with Z amount of money every six months’ or a similar arrangement), they are far from worthless. The general understanding is that the US government is one of the most secure, stable places in which to invest. (Treasury bonds are widely cited as an example of ‘risk free’ investments, with a chance of default that is minuscule, at most.) Going back to our analogy, it would be like writing yourself an IOU, if you had the power to tax millions of people and throw them in jail if they failed to pay; chances are that your IOU to yourself is going to be paid, one way or another.
So, Will Social Security Survive?
Ah, the sixty-four thousand dollar question. The short answer: yes, yes it will. While the trust fund is expected to run out in 2041 (and depending on a number of factors, that date could be shifted earlier or later, perhaps by a rather large margin), remember that the primary source of payment for Social Security benefits are current workers. As long as there are still young (or at least, non-retired) people working and paying taxes, there will be a source of funding for retirees. In fact, the above linked report notes that, in its current form, the Social Security system will be able to pay at least 75% of its promised benefits through 2082, the last year for which they ran projections. As long as you incorporate a potentially sizable dip in your promised benefits, including your expected Social Security payments in your retirement calculations can make a great deal of sense.
That said, for my own retirement planning, I try not to include any promised Social Security benefits. I have several reasons for this. First, you may have noticed that I highlighted ‘in its current form’; that’s because it’s possible, perhaps even likely, that our politicians will start to feel political pressure to tweak, or even completely overhaul, the system to make it more solvent, particularly as we get closer to the time when the trust fund runs out. It is possible, however unlikely, that they will even decide to end the program entirely (I have no doubt there are some individuals currently serving in Congress who’d support this approach) or at least, bar younger people from collecting benefits. I may personally doubt that it will come to that (and I do), but for someone like me, who’s measuring the time until he qualifies for benefits in decades, not years, a policy of not depending on Social Security benefits for retirement seems to be most appropriate.
Second, even if these more apocalyptic thoughts never come to fruition, there’s still the fact of the expected drop of 25% of benefits, perhaps more. Even assuming that Social Security is still paying out benefits to new retirees when I am old enough to retire (which again, I believe it will be), it’s hard to know how much I can expect to get in benefits. Somewhere between the idealistic estimates of the Social Security administration and the pessimistic predictions of bankruptcy, there is the actual amount I will receive when I reach retirement age. (An age which, while we’re on the subject, is likely to rise, to help deal with the large number of long-lived, healthy ‘old’ people retiring and then living for half a century or more on Social Security.) While I expect the Social Security Administration to treat me well when I hit retirement age, again it seems like a more cautious approach is to try to save enough to retire on my own, and consider any payment from Social Security as a nice bonus (and a healthy boost to my standard of living).
Speaking of retiring on my own, that brings me to the third reason I don’t include Social Security benefits in my retirement calculations: I don’t want to wait until I’m 65 (or whatever the retirement age has been set at when I reach that point) to retire. I’m hoping for (and doing my best to plan) a retirement at sixty, fifty, heck, even forty, if I can save and invest a huge amount over the next decade. While Social Security is a nice program, and certainly very helpful for numerous people, I hope I’m already retired well before I qualify.
There you have it, an explanation of the present (and future) of the Social Security program, why I am positive it will still be around (to some extent) when I reach retirement age (barring an act of Congress ending it, that is), and why, even with that knowledge, I don’t include Social Security in my calculations for retirement. Here’s hoping it provided you with some helpful retirement planning information!