PreFunding Senior Entitlements


How to Save Social Security and Medicare

The Problem:
Congress has promised that our seniors will have health care coverage and retirement income for the rest of their lives. Unfortunately, Congress has failed to pay for all the benefits they have promised. Now our children must deal with the $61.6 trillion shortfall[1]
 
Pay-As-You-Go Funding:
Social Security and Medicare beneficiaries are primarily paid from the payroll and income taxes that are collected today. This type of 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 effects 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.

The concept of "Pre-funding at Birth" takes full advantage of the time value of money. Pre-funding involves investing a relatively small amount of money at birth that grows unmolested until the beneficiary reaches a certain age – say 70 years old. The accumulated investment is then used to pay the beneficiary for the rest of their life. If you know how much money you want to receive in the future and you know the rate at which your investment will grow, it's a straightforward calculation to determine how much you'll need to invest today to reach your goal.

Compound Annual Growth Rate (CAGR):
Equity markets do not pay interest.  An investor makes money when the value of his or her equities increases or when the company pays a dividend. Because equity values can decline as well as increase, equity value changes are measured by a computation known as the Compound Annual Growth Rate (CAGR). For purposes of this discussion, CAGR and annual interest rate are synonymous.

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 returns the corresponding CAGR.

Risk Mitigation:
There is a widely held but patently false belief that pay-as-you-go-funding for critical programs like Social Security and Medicare is less risky than investing in the stock markets. While it is certainly true that markets can and do fluctuate widely over a five, ten or even a fifteen year period, it is also true that the longer the term, the less the risk in the markets.

Consider a funding plan that was based on the perpetuity of the equity markets. Such a plan could eliminate market risk and beneficiary angst altogether simply by fixing average annual returns for all beneficiaries at a rate that was a few tenths of a percent less than the historic average. The plan could instill confidence further by guaranteeing the benefits through the full faith and credit of the US government.

When you compare the risk realities between Prefunding at birth 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 still managed to average a 10.4% return on investment while pay-as-you-go financing has left us with a $61.6 trillion unfunded liability against our children's future. Nice legacy. Which financing strategy would you say is less risky?

A Social Security Example:
In 2007, the average Social Security benefit was $12,972 per year. According to the Bureau of Labor Statistics, a person who turned 70 in 2007 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]. The lifetime payout after 14 years was expected to be $218,664[4].

Pre-Funding vs. Pay-As-You-Go:
How would Prefunding at birth compare with Pay-as-you-go financing from an historical perspective? Well, given our 10.4% average return on investment and a 2.8% average annual inflation rate, how much would taxpayers have had to invest one-time in 1937 in order to be able to payout $218,664 over 14 years beginning 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 January 1, 1937 and the Social Security Administration had deposited $121 for you in a fund that grew on average 10.4% per year, at age 70, you could start withdrawing $12,972 per year. Each year you could receive 2.8% more than the year before to cover inflation. You could receive that inflation adjusted payment each year for the rest of your life (estimated at 14 years). At the end of those 14 years, you would have received the same $218,664 that Social Security would have paid you if Social Security had the money, which under current funding law, it would 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 and employers 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.

That's looking at Prefunding from an historical perspective, but what about the future. The BLS.gov forecasts that average life expectancies for a 70 year old will increase from 14 to 18 years. So, how much would it cost today to prefund a newborn’s Social Security account that begins paying benefits 70 years from now? With an average annual growth rate of 10.4%, average annual inflation rate of 2.8% and a life expectancy of 18 years, the answer is $750. 

With roughly 4 million Americans born each year, the cost to fund a program that deposits $750 in an account for every newborn American is about $3 billion per year ($750 X 4 million births).

How much is $3 billion per year? To put it in context, consider that we spend about $2 billion per week in Afghanistan. In other words, the annual cost to prefund Social Security is equivalent to about 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. If that surplus had been hidden in a mattress, it could prefund Social Security for the next 40 years ($125 billion / $3 billion per year). But suppose the $125 billion had been invested in non US debt. Any return slightly greater than 2.4% on $125 billion could pay for the prefunding program indefinitely. ($125B x .024 = $3B).

Conclusion:
Pre-funding at birth can resolve the financing problems confronting both Social Security and Medicare. Transitioning from pay-as-you-go to pre-funding would place us on a glide path to eliminate the $61.6 trillion in unfunded liabilities and save Social Security and Medicare from financial crisis. Americans need to be aware of this solution and demand that Congress save our senior safety net and keep the promises they 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)
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