We Can Save Social Security and Medicare with
Pre-Funding at Birth
The Problem:
Congress has promised our retired seniors health care coverage and retirement income for the rest of their lives. Unfortunately, Congress has failed to pay for the benefits they promised. Now all Americans must deal with the $61.6 trillion cost[1] of their broken promises.
Pay-As-You-Go Funding:
Social Security and Medicare beneficiaries are paid from taxes collected today. This type of program funding is called Pay-As-You-Go.
Pre-funding at birth:
The greatest criticism of pay-as-you-go funding is that it ignores the wealth accumulation derived from the time-value-of-money. The time value of money is defined as the growth of money over time due to the compounding of interest.
Pre-funding at birth capitalizes on the time value of money. Pre-funding invests a relatively small amount of money at birth that grows until the beneficiary reaches a certain age – say 70 years old. The investment then pays the beneficiary for the remainder of their life.
Compound Annual Growth Rate (CAGR):
Equity markets do not pay interest. You make money when the value of your equities increases or when the company pays you a dividend. Equity value changes are measured by a computation known as the Compound Annual Growth Rate - CAGR. For purposes of this discussion, you can think of the CAGR as the same as an annually compounded interest rate.
CAGR History:
Using stock price and dividend yield data for over 100 years, U.S. equities, including reinvested dividends, have delivered a CAGR of 10.4%. The worst 70-year period since 1915 still returned a very respectable CAGR of 9.85% while the best 70-year period returned a CAGR of 11.92%[2]. The site www.moneychimp.com/features/market_cagr.htm allows you to enter a date range and then displays the CAGR for the period you enter.
Risk Mitigation:
There is a widely held belief that pay-as-you-go-funding for Social Security and Medicare is less risky than investing in the stock markets. While it is true that markets fluctuate widely over a five, ten or even a fifteen year periods, it is also true that the longer the term, the less the risk in the markets. A plan based on the perpetuity of equity markets could eliminate market risk by fixing returns at slightly less than historic CAGR averages and offering guaranteed benefits through the full faith and credit of the American taxpayer. When you compare the risk realities between equity markets and pay-as-you-go financing for Social Security and Medicare, the facts are hard to dispute. Even including the Great Depression and the current Great Recession, equity markets have averaged a 10.4% return on investment while pay-as-you-go financing has left us with a $61.6 trillion unfunded liability. Which one makes more sense to you?
A Social Security Example:
In 2007, the average Social Security benefit was $12,972; a person who turned 70 years old was expected to live another 14 years; each year Social Security payments were expected to grow 2.8% to cover cost of living increases. [3] Therefore, the total Social Security payout to a 2007 retiree over 14 years is expected to be $218,664[4].
Pre-Funding vs. Pay-As-You-Go:
Given our 10.4% CAGR standard and a 2.8% annual inflation rate, how much would taxpayers have had to invest in equities on 1/1/1937 in order to payout $218,664 over 14 years starting in 2007? The answer is $121.
You might want to read that last paragraph again – let it sink in.
In other words, if you were born on 1/1/1937 and the Social Security Administration had deposited $121 for you in an equity-indexed fund that grew at the average CAGR of 10.4%, at age 70, you could start withdrawing $12,972 per year. Each year you could receive 2.8% more than the year before to account for inflation. You could receive that inflation adjusted payment each year for 14 years or until you reached 84 years old. At the end of those 14 years, you would have received the same $218,664 that Social Security would pay you if the program had the money, which it does not. Said another way - $121 Pre-Funded at birth is the same as $218,664 Pay-As-You-Go.
Compare the one-time investment of $121 made 70 years ago against the $218,664 that must be taken from workers over the next 14 years. Moreover, that is just one person. Had Social Security and Medicare included pre-funding at their inception, then those programs would be adequately funded today and more importantly, forever.
Even though Social Security cannot meet its obligations under current funding law[5], the Social Security Administration still computes what benefit payments will be up to 75 years from now if the plan were adequately funded. In theory, future benefits represent how much money you would need then to purchase the same things $12,972 purchased in 2007. The obvious question becomes – Given our CAGR standard rate of 10.4%, how much would we have to pre-fund a newborn’s Social Security account that begins paying benefits 70 years from now to a beneficiary who is expected to live an additional 18 years? The answer is about $750.
There are about 4 million Americans born each year. The cost to taxpayers to fund a program that deposits $750 in an account for every newborn American is $3 billion per year ($750 X 4 million births).
How much is $3 billion per year? We spend about $2 billion per week in Afghanistan. In other words, the cost to pre-fund Social Security at birth each year is equivalent to 10 1/2 days in Afghanistan. In 2009, Americans paid $805 billion to Social Security. Social Security paid out $680 billion in benefits and Congress spent the remaining $125 billion Social Security surplus on programs unrelated to Social Security. Just the $125 billion surplus in 2009 could pre-fund Social Security for 41 years ($125 billion / $3 billion per year).
Conclusion:
Pre-funding at birth will solve our Social Security and Medicare financing problems. Transitioning from pay-as-you-go to pre-funding puts us on a glide path to eliminate the $61.6 trillion in unfunded liabilities and save Social Security and Medicare from financial disaster. Americans need to be aware of this solution so they can demand that Congress save our senior safety net and keep the promises our politicians made.
To learn more about how pre-funding can save our Senior Safety-Net programs, please review the position paper ABC – Social Security.
[1] http://www.usatoday.com/news/washington/2011-06-06-us-owes-62-trillion-in-debt_n.htm
[2] http://www.econ.yale.edu/~shiller/data.htm Robert Shiller: The data collection effort about investor attitudes that I have been conducting since 1989 has now resulted in a group of Stock Market Confidence Indexes produced by the Yale School of Management. These data are collected in collaboration with Fumiko Kon-Ya and Yoshiro Tsutsui of Japan. Some of our earlier results are also noteworthy.
Stock market data used in [Robert Shiller] book, Irrational Exuberance [Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005] are available for download, Excel file (xls). This data set consists of monthly stock price, dividends, and earnings data and the consumer price index (to allow conversion to real values), all starting January 1871. The price, dividend, and earnings series are from the same sources as described in Chapter 26 of my earlier book (Market Volatility [Cambridge, MA: MIT Press, 1989]), although now I use monthly data, rather than annual data. Monthly dividend and earnings data are computed from the S&P four-quarter tools for the quarter since 1926, with linear interpolation to monthly figures. Dividend and earnings data before 1926 are from Cowles and associates (Common Stock Indexes, 2nd ed. [Bloomington, Ind.: Principia Press, 1939]), interpolated from annual data. Stock price data are monthly averages of daily closing prices through January 2000, the last month available as this book goes to press. The CPI-U (Consumer Price Index-All Urban Consumers) published by the U.S. Bureau of Labor Statistics begins in 1913; for years before 1913 1 spliced to the CPI Warren and Pearson's price index, by multiplying it by the ratio of the indexes in January 1913. December 1999 and January 2000 values for the CPI-Uare extrapolated. See George F. Warren and Frank A. Pearson, Gold and Prices (New York: John Wiley and Sons, 1935). Data are from their Table 1, pp. 11–14. For the Plots, I have multiplied the inflation-corrected series by a constant so that their value in january 2000 equals their nominal value, i.e., so that all prices are effectively in January 2000 dollars.
[3] SSA.gov Social Security Administration, Master Beneficiary Record, 100 percent data. SSABenefits2.xls (sheet 2: 12/2007)
[4] http://www.financeformulas.net/Present_Value_of_Growing_Annuity.html#Calc-Header Present value of a growing annuity.
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