Government Spending: Social Security, Part 1

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7 MIN READ - Last month the Cautious Optimism Correspondent for Economic Affairs (and Other Egghead Stuff) posted several articles on military spending. Today we focus on some history and problems with the federal government’s single largest 2023 budget outlay at $1.35 trillion: Social Security.

First a little history.

Social Security was founded in 1935 as one of President Franklin Roosevelt’s many New Deal programs. At its inception a 1% tax was imposed on all worker paychecks with another 1% taken from the employer for a total of 2%.

Fully aware that the number of retirees would grow over time the Social Security payroll tax was scheduled to rise to 2% + 2% in the 1950’s and stay there for good.

It didn’t take long for the government to break that promise. The tax was raised to 2.25%+2.25% in 1957, to 2.5%+2.5% in 1959, and 3%+3% in 1960. And up and up it went over two more decades despite tens of millions of baby boomers entering the workforce.

For those who haven’t checked their paycheck stubs lately, the Social Security payroll tax has been 6.2% paid by workers and 6.2% by employers since 1990 (12.4%), yet the program has been running large deficits for years now and is expected to be unable to pay promised benefits as early as 2034.

VERY POOR RETURNS

The Economics Correspondent considers himself a halfway decent retirement planner and years ago, when he first noticed the Social Security Administration was taking 12.4% out of everyone’s paycheck (subject to a salary cap that is currently set at $160,200), his first thought was “Hmmm, 12.4% is considered a *very* healthy chunk to save for one’s retirement already. Just how well could a worker do on his or her own saving 12.4% instead of Social Security doing it for him?”

So if we open a spreadsheet and plug some numbers in, we get some interesting and sadly predictable results.

Starting with a minimum wage worker right out of high school at age 18, if the employee:

-Earns the federal minimum wage of $7.25 an hour
-Works 40 hours a week
-Is lazy and never works an hour of overtime
-Is unambitious and never gets promoted
-Is unambitious and never gets a raise… only the occasional bump in minimum wage to adjust for inflation
-We assume an average annual inflation rate of 2.5%
-We take the standard 12.4% from his paycheck
-We compound a modest stock market annual return of 9% over many decades (the S&P 500 has averaged 11% for the last 50 years)…

At age 72 our minimum wage worker with zero ambition has a nest egg worth of $3.18 million earning $23,843 a month in interest.

Of course by age 72, after years of inflation, $23,843 won’t be worth what it is today. So adjusting for inflation his monthly interest payments will be $6,291 a month in today’s dollars (about $75,500 a year) but our worker also has his $3.18 million nest egg to slowly tap into.

And in deep blue states where the minimum wage is over double the federal floor all these numbers more than double to greater than $6.36 million and inflation-adjusted annual payments of $150,000.

How does Social Security treat these minimum wage workers?

According to the Social Security Administration’s online calculator, the same worker can expect at age 72 to receive $6,961 per month in the future which, in today’s dollars, is $1,300 or $15,600 a year.

$75,500 a year vs $15,600 a year.

Oh, and the worker’s nest egg, which doesn’t really exist under Social Security anyway, goes to the government.

This all assumes Social Security can keep all its promises decades from now.

And of course we’re talking about an unambitious lifetime minimum wage worker. What about a middle-class worker averaging $60,000 a year over a lifetime, starting working at age 22 right out of college (with adjustments for inflation)?

Well investing his own money, by age 72 our middle-class worker is worth $8.9 million earning $66,500 a month.

Adjusting for inflation in 2023 dollars that’s a nest egg of $2.6 million earning $19,331 a month or $232,000 a year.

According to Social Security’s online calculator that same worker gets a monthly benefit of $2,785 or $33,420 a year: one-seventh as much.

And don’t forget there’s no nest egg to tap into. His $8.9 million disappears.

Which raises an interesting question: Why would anyone who works ever want Social Security? The program pays a negative inflation-adjusted return on investment and anyone who works can do better on their own.

PAY AS YOU GO

One of the fundamental problems behind Social Security’s lousy returns is that it was originally (and deliberately) set up as a “pay as you go” program instead of the alternative “fully funded” version.

In a “fully funded” retirement program, money is taken out of your paycheck and put in an individual investment account where it earns real returns. Once you reach retirement age your money has grown over decades and it’s waiting for you to tap into your own account. 

Self-funded retirement schemes, such as those in Singapore, Hong Kong, Chile, Poland, Sweden, Malaysia (and more) are like a mandatory IRA or 401k; the government is forcing you to save for retirement, but the money is yours and yours alone. It doesn’t get diverted to another retiree in return for only a promise to pay you later.

“Pay as you go” programs like Social Security don’t put worker proceeds into a retirement account to grow but rather instantly transfer the money to elderly retirees. Instead of investments that grow the worker’s retirement balance, today’s workers are told they will receive their pensions via direct transfers from another generation of workers 10, 25, or 50 years from now.

Hence one of the key problems with “pay as you go” programs is the payroll taxes aren’t invested in anything and don’t grow (exception, the late 1980’s/1990’s “surplus” which was spent by Congress). The only thing that grows is the size of the promises made to today’s workers regarding what they’ll get decades from now when they retire.

Also, unlike fully funded programs, worker contributions are diverted immediately for consumption spending instead of investment spending. Across the entire system there is no deferral of consumption which also trims long-term economic growth. 

Some people call this arrangement a Ponzi scheme, but is it? Well, one definition of Ponzi scheme the Correspondent found is:

“A fraudulent investment scheme in which an operator pays returns on investments from capital derived from new investors, rather than from legitimate investment profits… … Ponzi schemes generally fall apart when there is not enough new capital to pay the ever-growing pool of existing investors.”

In which case Social Security is technically not a Ponzi scheme. Because private investors can choose not to hand their money to a bankrupt Ponzi scheme whereas Social Security simply confiscates workers’ money by force.

So why did Congress and FDR set up Social Security as an inefficient pay as you go program? Two reasons mostly.

The first was to get votes *now* and *today*, not decades later. In 1935 FDR’s reelection was coming up in one year, and telling seniors that “sorry, the program isn’t going to give you much by Election Day because your contributions won’t have added up in one year” wasn’t going to get him the votes he wanted to win in 1936. Instead FDR told seniors they would start receiving large payments funded by workers ASAP, and many of them rewarded the incumbent president with their votes.

The other reason was more cynical. There is documented evidence that FDR or at minimum FDR’s New Dealer aides wanted Social Security to be a program that no one could ever get rid of.

According to liberal historian Arthur Schlesinger, FDR explained in 1941 that…

“We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program.”

Today the Social Security Administration argues that these weren’t really FDR’s words but rather one of his top New Dealers, Luther Gulick.

Either way, it’s the program FDR approved and signed into law, and the vision turned out to be quite prescient. Like a hook in a fish, there’s now no easy way to transform Social Security into a fully funded program or wind it down.

If anyone tries to change Social Security to a fully funded program, payroll taxes taken from worker paychecks will go into the workers’ individual accounts instead of directly into retired seniors’ pockets—and seniors who were promised decades ago that they would get their regular Social Security payments at retirement will scream bloody murder (rightfully so) that they aren’t getting their money back as promised.

So if any politician tries to make Social Security more sustainable or fully funded, an entire generation of retirees will get stiffed and rise up in revolt, something FDR and his New Dealers foresaw.

The only ways the Economic Correspondent can see Social Security mathematically transforming into a fully funded program are:

1) Bankruptcy and restructuring (i.e. someone doesn’t get at least part of what they were promised).

2) Attempting to divert some contributions into higher yielding investments to plug the gap over many years. George W. Bush proposed this in his second term and was instantly excoriated by senior citizen lobbies who feared it would mean fewer payments—egged on by Democratic politicians who argued George W. Bush planned to bankrupt Social Security in the “Wall Street casino.”

3) Plugging the hole with a large one-time transfer from general tax revenues.

4) Going back to 1935 in a time machine and starting over.

The Economics Correspondent sees a combination of #2 and mostly #3 as the best option for making sure everyone gets what was promised to them while spreading the pain around as evenly as possible, but even #2 faces harsh political realities which will probably make it impossible.

Hence when Social Security is forecast to hit the wall in 2034 and no longer fully pay promised benefits the Correspondent suspects the federal government will either raise the payroll tax even higher, cut benefits for wealthier retirees (aka. “means testing” or reneging on promises to evil, comfortable retirees who committed the sin of being responsible during their working years), raise the retirement age by a few years to lower its overall payouts, or some combination of all three.