Pennsylvania Investment Observer

Undoing the Ponzi Scheme of Social Security

by Daniel J. Nestlerode

Presidential candidate George W. Bush has proposed, as have others, allowing the working classes the option of investing two percentage points out of 12.4% of payroll taxes into separate taxpayer owned investment account. Currently, working people put 6.2% of their gross pay into social security. Their employer matches this 6.2%, totaling an investment of 12.4% of your gross payroll into your social security retirement account. This year, this tax is computed on the first $76,200 of gross payroll or $9449 at the maximum pay. Needless to say, this is a great deal of money that flows into the social security administration coffers each year. For many low-income people, the social security tax exceeds all their other taxes.

Unlike insurance and annuity contracts, which are designed to be actuarially sound, social security is a pay as you go system. What this means is that each worker does not have an assigned pool of assets securing his or her retirement. Rather, the monthly benefits paid out by social security come from the taxes being paid in current workers. To this end, social security is an intergenerational transfer or money from younger working people to older retired people. In other words, if no one were working, there would be no social security benefits. To this end, social security is a Ponzi scheme in that the earlier retirees get the greatest benefits, while later participants might not receive benefits in proportion to their paid taxes into the system. The Bush proposal estimates that today an average worker will earn only 1.9% per annum on his or her contributions to social security. Demographics supply the compelling facts governing social security payments and taxes. As we transition from a society with many workers and few retirees to one with many retirees and few workers, the relationship between the taxes and the benefits goes askew. Indeed, at current rates, social security will go bankrupt before the middle of this century if current demographic trends are played out and tax rates are not increased or benefits are not reduced.

Social Security is the so-called third rail of politics, the one with the electricity in it. If you are a politician and you recommend changes in the system, you're likely to get burned. People believe, wrongly, that social security is an entitlement and that we have a right to receive benefits. This is simply not true. There is no account at the social security administration with your name engraved on it waiting for you when you retire. Benefits are entirely dependent on political will of the government and incoming social security taxes from workers. Right now we are all (except for some municipal workers, clergy and religious sects) stuck with a system that eventually will pay out less in benefits that was paid in via social security taxes.

Bush's proposal allows workers to take two percentage points of their social security taxes and invest it in an account earmarked for retirement, much like an IRA account. While investment options are not well defined, I favor an account that would allow each individual a broad range of investment options under their personal control. This move could shift an enormous amount of funds from government coffers into the private sector, possibly including bank savings accounts and certificates, money market mutual funds, stocks, stock mutual funds including index funds, annuities, corporate bonds and other financial investments. Money so invested would then be available to private enterprise to fund loans and build equity capital in the economy, providing the capital for the growth and development of our economy in the future.

Historically, private investment has returned much better benefits than government bonds or similar guarantees. At the same time, now that 50% of Americans households have some investment in the stock market, encouraging others to learn about our economic system of free market capitalism would yield tremendous benefits. Being poor for most people is a sign of incompetence in dealing with money and investment. Moving part of social security to market investments would encourage more people to learn about their options and expected outcomes of managing their own investment programs. As securities regulators have often mentioned, an informed competent investment community is much less likely to be defrauded by the criminal community and more likely to effectively accumulate wealth.

Furthermore, social security saving funds would be owned by the worker and would be passed on to future generations. Current social security benefits end at the death of the worker, with no estate passed on to spouses or children.

The impact of investing two percentage points of social security taxes into the private sector can only be speculated upon. Certainly, the financial community would have to gear up to handle many new investors. Clearly the industry would have an educational job to handle. The cash flowing into investments would better fund out economy, making us less dependent on foreign investment. It is not at all clear that stock prices would move higher, as many new investors would likely take very conservative balanced approaches to investment, placing a significant portion of new money in bonds and savings accounts. I suspect much of the "new" money would flow directly into mutual funds, banks and similar institutions as new investors grope for understanding of their new investment opportunities.

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