Mark Miller: Remaking Retirement

Fact Finding on Social Security

Mark Miller

"Facts are stubborn things," John Adams said in 1770. My recent Morningstar column on myths and facts swirling around the Social Security system stirred quite a bit of passionate political debate, judging by the comments posted to the article.

But even amid stark disagreement, at the core of the system are certain facts that can be useful to any investor trying to understand Social Security and where it fits into his or her retirement plans. Several aspects of the program are worthy of debate, and by clarifying the facts, I hope to make those conversations more productive.

In that spirit, and in response to some of the most interesting comments from readers of my first article, here are some further facts on Social Security.

I.O.U.s 
Social Security critics argue that the Social Security Trust Fund is an accounting gimmick because its assets have been lent to the government via special-issue Treasury bonds. I pointed out that the bonds are "full faith and credit" obligations of the government--therefore, they are real assets.

"How can you possibly believe that the special-issue bonds represent real assets?" writes John Dewey in a typical response. "The special-issue bonds are nothing more than IOUs from one part of the government (the taxpayers) to another. There is nothing in current law that requires these bonds to ever be redeemed."

In fact, under federal law, the financial assets held by the retirement and disability trust funds can be used only to meet the obligations of these programs. (See Section 201(d) of the Social Security Act.)

It's also important to understand that the special notes aren't just sitting in a vault--they are being redeemed regularly. Steve Goss, chief actuary of the Social Security Administration, describes the process:

"New bonds are purchased every day from the revenue coming into the government, and they are credited to the trust funds. Similarly, whenever any money is expended from the trust funds, for benefits or for any administrative expenses, this comes from redeeming bonds. So, bonds are issued and redeemed all the time.

"This is significant because there is a strict rule on the priority order for redemption of bonds. Anytime a bond is redeemed, we redeem from among those bonds with the shortest remaining duration to maturity, and redeem the bond from that group that has the lowest interest rate. New bonds issued are always issued with an interest rate compounded semiannually at the average effective market yield determined by the Treasury Department at the close of the prior month for all outstanding marketable Treasury securities that are due or callable four years or more in the future. We also have specific procedures for the term of bond issues and the date of rollover."

Although most trust fund assets are held in the special Treasury notes, Goss says that the key legal requirement is that the funds be invested in interest-bearing securities "backed as to principal and interest by the full faith and credit of the U.S. government."

The trust funds don't have to invest solely in special-issue bonds and have not always done so in the past. "Marketable Treasury securities and some mortgage-backed securities also qualify, but none are held by the trust funds currently," he says. For more on this, see Social Security Administration actuarial note 142--the first memo on this page.

Why doesn't the trust fund also invest in corporate bonds or stocks? Politics.

When the Social Security Act was passed in 1935, the original intent was to invest in all kinds of private-sector assets--an idea that sparked resistance from conservatives, who disliked the socialistic implications of having the government invest directly in the private sector.

Senator Arthur Vandenberg, a Michigan Republican who was a key opponent of most aspects of the New Deal (but did support the creation of Social Security), was concerned that the large trust fund Social Security was expected to build up would result in a kind of socialism.

"He had a somewhat famous exchange with Arthur Altmeyer, the first chair of the Social Security Board, in which he asked Altmeyer what the trust fund assets might be invested in," says Eric Laursen, author of The People's Pension: The War Against Social Security from Reagan to Obama. Altmeyer replied, in 'social undertakings such as . . .  low-cost housing, schools, hospitals,' and even in manufacturing 'that could be justified from the point of view of social welfare.'

"That scared the bejeezus out of Vandenberg, who went on to insist that the trust fund be shrunk and invested in Treasury bonds."

We're All Greek Now
Some readers just aren't buying my argument that Social Security can't bankrupt the federal government because the U.S. government has the power to tax and print money, unlike the troubled Mediterranean country that is the poster child of the European sovereign debt crisis.

Inspectorgadget's comment is typical of the thread: "Essentially [Miller] says, in several different ways, 'Don't worry, the government owes Social Security all this money, future taxes can be raised to cover Social Security.' That's the problem, isn't it? Taxes on whom? On the shrinking workforce to pay for a growing retiree population? Has this expert looked at the newspaper lately to see news about Greece (for example), to see where this leads?"

Of course, Greece is a eurozone country, at least for the moment--which means it is in a monetary union and can't make decisions on its own to print money. Furthermore, financial markets don't seem to share the reader's concerns. Ten-year U.S. Treasury notes are yielding about 1.6%--not far off record lows and hardly a rate that any sane investor would accept for 10 years from a borrower that is headed for bankruptcy. Compare that to recent 6.8% yields on the 10-year notes of Spain, another stressed eurozone country.

This is not to dismiss the long-range importance of the debt problem for the U.S. economy--or the inflationary risks inherent in printing money. But the option to inject liquidity into the market does mitigate the crisis notion of a sudden bankruptcy where debts cannot be repaid, as we are seeing in Greece and Spain. Moreover, the market itself is not pricing U.S. sovereign debt anywhere near crisis levels.

China Syndrome
I argued that Social Security isn't, per se, a contributor to the national debt. In fact, the program is a lender, not a borrower. Just like the Chinese.

"The truth is that to say Social Security will not be a major, and growing, contributor to the national debt is simply intellectually dishonest," writes damich44. "The Social Security Trust is the single largest creditor of the U.S. government, and it isn't close."

My point on this is simple: debt obligations are debt obligations, whether they are to a sovereign foreign government or to Social Security. And remember--an obligation to Social Security really is an obligation to the American people, who have "lent" their FICA tax contributions to the government--tax contributions that were made with the promise that they would be used to fund their future Social Security benefits.

Social Security's old-age and disability trust funds currently hold $2.7 trillion in bonds. As of June 2012, the two biggest sovereign holders of U.S. Treasury obligations were China ($1.164 trillion) and Japan ($1.119 trillion). At $5.292 trillion, all foreign sovereign debt holdings dwarf Social Security's holdings.

Taxing Payroll
Several sharp-eyed readers caught my error in describing one of the revenue-raising ideas that has been floated--namely, subjecting worker 401(k) contributions to payroll tax. Retirement accounts already are subject to Social Security taxes; advocates actually have proposed ending exemptions for other salary-reduction plans, such as flexible spending accounts for health care or transportation.

The change would treat these other salary-reduction plans like 401(k)s, meaning they would be exempt from income taxes but subject to Social Security taxes. Since the amounts of the contributions to those salary-reduction plans would be counted as covered income for Social Security, it would also increase that person's benefit somewhat.

What Would FDR Do?
Flip Carroll suggested that President Franklin Roosevelt really wanted Social Security to be structured as a personal investment account, rather than pooled social insurance.

"I do not have the primary source, but I have been told by a number of political-science and economic experts that Roosevelt originally intended Social Security to act like an investment account. Essentially, everyone was required to contribute money over his/her working lifetime. After 'retirement age,' let's call it, he/she received an annuity for life."

But Social Security historians haven't found any evidence that Roosevelt wanted private accounts. Nancy Altman, author of The Battle for Social Security: From FDR's Vision To Bush's Gamble, notes that FDR did originally propose an annuity as an add-on or supplement to the core program, but the idea was rejected by Congress because opponents feared it would compete unfairly with private insurance.

Adds Laursen: "The evidence I've seen indicates pretty strongly that FDR wanted Social Security to behave as much as possible like a private insurance program--he never advocated giving everyone a separate account.

"More generally, it's very hard to talk about what FDR originally intended because he kept talking, writing, and legislating on it for the rest of his tenure as president. For instance, four years after signing the Social Security Act of 1935, he signed the 1939 Amendments, which changed the program substantially. Among other things, the amendments created survivors insurance for widows and orphans--which obviously aren't features found in annuities or investment products."

Finally, Laursen notes that, "Social Security is the one thing you can rely on even if you lose all your other resources. No other investment product can claim that. And, it's inflation-protected, which you'd have to pay a fortune to obtain with any other investment product."

Janitors and Lawyers
Some readers disliked my suggestion that no one should have to slave away cleaning bathrooms into their 70s. The issue here is longevity; I argued that longer life spans aren't good cause for a higher retirement age.

Some were especially incensed that I quoted Paul Krugman, the liberal Nobel Prize-winning economist.

"As for Krugman's usual far-left blather about janitors and lawyers, it remains a fact that janitors are also living longer, so a higher retirement age is no more unfair than before, or than any other annuity," writes Darwinian. "Why doesn't Krugman whine that Social Security is unfair to men, since women also live longer?"

But the point is, longevity gains are not distributed evenly among the population. The largest gains have gone to higher-income people who are better equipped to work longer since their jobs do not involve physical labor. Does it make sense to ask low-wage workers who do tough manual jobs to keep working into their 70s?

This point also bears repeating: The longevity argument masks the fact that a higher retirement age results in a substantial across-the-board benefit cut--no matter when you retire--because it raises the bar on how long you need to wait to receive a full benefit.

The Meaning of Means Testing
There was plenty of confusion about the idea of means testing Social Security.

"Why do people group Social Security and Medicare with Medicaid?" writes WillieB. "With Social Security and Medicare, individuals such as myself and their employers pay into it . . . with Medicaid it is purely welfare, to receive it you are not required to pay a dime. It's apples and oranges."

You're right, WillieB. Social Security and Medicare are earned benefit programs that serve all income brackets. Although benefits are most meaningful to lower- and middle-class households, no one is subjected to a means test to prove they qualify. If you've paid sufficiently into the system, you get benefits. By contrast, Medicaid is a means-tested health-care program for poor people.

Guyjohn argued that Social Security does employ means testing: "Social Security 'bend points' (in the benefits formula) are the equivalent of means testing," he writes.

The phrase "bend points" refers to a Social Security formula that measures the income you earn during your working years, and translates that to a benefit.

More specifically: "Bend points are the portions of your average income (Average Indexed Monthly Earnings--AIME) in specific dollar amounts that are indexed each year, based upon an obscure table called the Average Wage Index (AWI) Series," writes financial planner Jim Blankenship. "They're called bend points because they represent points on a graph of your AIME graphed by inclusion in calculating the [Primary Insurance Amount.]"

AIME looks at your earnings history. A means-tested program, such as Medicaid, looks at your current means at the time you are seeking a benefit. For example, fairly affluent people who need nursing-home care have been known to cast off their assets down to poverty levels in order to qualify for Medicaid to pay for their care.

Aging Boomers
"Good piece, but I can't believe [you] left out the number-one myth," writes Justin Simmons, "that the Social Security deficit is the result of the baby boomers getting ready to retire, increasing payouts. People forget the system was brought into full 75-year actuarial balance by the Greenspan Commission, appointed by President Reagan and House Speaker Tip O'Neill in the early 1980's. Since the last baby boomer was born [in the early '60s], it is impossible that this demographic could be contributing to the shortfall since the 1984 rebalancing."

Good point, Justin. Although politicians routinely state that Social Security's problems result from our growing elderly population--or longevity gains--the age issue really is about birth rates. After the baby boom ended in 1965, U.S. birth rates fell to the lowest ever in our history--1.74 births per woman, on average, in 1976, before stabilizing later at 2. So the real issue here is the change in the ratio of workers to retirees. The SSA's Goss described it to me this way earlier this year in an interview for Reuters:

"Imagine that in an earlier generation each of us had three children. So when we get old and retire, we each have three kids in the work force contributing toward taking care of us--chipping in to buy us a house or pay our rent, or paying in to Social Security. But back in that 1965-to-1976 period, we shifted to having only two children. If only two kids are sharing that burden, that's got to be either half again more they will put on the table, or one third less that we're going to get--it's just straight-up arithmetic. Or we have to find a way to extend the time period over which we can work."

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.