To summarize the 2012 Medicare
and Social Security Trustee reports:
If
Congress fails to change the senior entitlement laws, Medicare will be unable
to pay full benefits beginning in 2024 and Social Security will only have the
resources to pay three quarters of its scheduled benefits starting in 2033.
The Trustees are telling us,
just as they have been telling us for years, that Congress has promised but neglected
to pay for over $63 trillion worth of senior benefits.[1]
Our chronic failure to
resolve this decades old problem is a measure of how incompetent our federal
government has become. But perhaps equally as distressing is how suboptimal,
short sighted and narrow minded are the proposed solutions being bandied about.
To solve our senior
entitlement funding problems, the Democrats propose raising taxes. The Republicans
counter that the nation can no longer afford to pay the ever escalating benefits
and that raising taxes will further damage our already fragile economy. Because
of this, the Republicans propose reducing the senior benefits that have been
promised to millions of American voters for decades – good luck with that.
Most experts agree that on
the brink of economic collapse Congress will reluctantly reach a poorly
reasoned, ill advised compromise that incorporates some combination of both
raising taxes and reducing benefits. The ultimate effect of this last minute
deal will be to subject our economy to slower than necessary growth; higher
than necessary unemployment and the continued erosion of our standard of
living.[2]
There is a better way!
We can restore our senior
entitlement programs to solvency simply by changing how we fund them. For a fraction
of what it costs our economy today, a sensible funding approach would place our
senior programs on a glide path toward permanent fiscal soundness without the
need to increase anyone’s taxes or reduce anyone’s benefits. Does all that
sound a little too good to be true? Read on.
Albert Einstein, perhaps America’s most
renowned physicist and certainly one of the world’s most brilliant historical
figures is often credited with saying that the most powerful force in the
universe is compound interest. Whether Professor Einstein actually expressed
that sentiment is not important; what is important is the fact that the basis
of capitalism and the foundation for the U.S. economy is predicated on the
notion that private capital, invested in a profit motivated enterprise, may
grow over time. The reason why people lend their money to, or invest their
money in an enterprise is because the lender/investor expects to get more money
back in the future. Without this fundamental principle of private capital
appreciation, capitalism could not exist.
Our senior programs would have
served America’s
interests better had they been designed from the outset as investments in our seniors’
futures and taken full advantage of capital appreciation and the time value of
money for the life of the beneficiary. Instead, they were designed as insurance
programs where the premiums paid today are used to pay today’s beneficiaries.
This type of funding is referred to as Pay-As-You-Go. When you consider that
people will have to live at least 62 years before they receive their first
benefit, pay-as-you-go is perhaps the most inefficient money management strategy
conceivable.
Saving our senior safety net
is as simple as fully utilizing the power of compounding for the life of the
beneficiary. We call this whole-life investing strategy Pre-funding at Birth.
Let’s use an analogy to
explain the approach.
Yesterday your first child,
Jane was born and today you want to do something nice for Jane’s future. After
some research and a little planning, you’re satisfied that you’ll be able to
take care of baby Jane’s daily needs including her education and health care. But
now you would like to do a little something for Jane’s old age – say when she
reaches 70 years old. What a good daddy.
After selling your baseball
card collection and the banged up old Harley-Davidson your wife affectionately
refers to as the coffin, you were able to scrounge up another $2000 to help
fund baby Jane’s retirement. But what should you do with the money?
You could do what our
government does and spend the $2000 today and promise little Janey through an
IOU that someone else will provide for her when she retires. Of course since
you are a good daddy and possess a modicum of common sense, you immediately
reject that idea as irresponsible.
You could decide to put the
money in a safety deposit box and set up a trust fund with a law firm
stipulating that baby Jane receives the $2000 when she reaches age 70. But you
also know that inflation will eat away at the purchasing power of the money.
You’re worried that after 70 years, $2000 might only buy little Jane a loaf of
bread or two. You don’t know much about investing so you decide to consult a
lawyer friend of yours for some free advice.
After reviewing a list of
investment alternatives, your lawyer friend Loretta recommends that you invest the
$2000 in the stock market. In particular she suggests an index fund that tracks
the S&P 500.
You express grave concern
over the safety of the stock market. Seeing your concern, a patient Loretta provides
you with the following facts.
- Since 1915, U.S. equities have returned an
average annual return of 10.4%. That time frame includes the two deepest
and longest economic downturns in U.S. history; the Great
Depression and the Great Recession.[3]
- In all that time, the worst 70 year period still
managed to return a very respectable 9.85% average per year. In other
words, pick any 70 year period since 1915, and the worst average return on
your investment would have been 9.85% per year.
- The best average annual rate of return over any
70 year period since 1915 was 11.92%.
- The U.S. Senate Special Committee on Aging
report entitled “Social Security Modernization Options to Address Solvency
and Benefit Adequacy” dated May 13th, 2010 concluded that over
the long term a government controlled broad based equity fund would
average 9.4% annual returns on investment after accounting for fees and
expenses.[4]
Even after considering what
Loretta just told you, you’re still feeling a little uneasy. You don’t trust
the stock market. You tried it a couple times and always got burned. You tell
Loretta, “The market is too risky. What are you not telling me?”
Loretta tells you “The stock
market is risky over the short term such as a year, five years or even fifteen
years. It is also very risky if you’re not an expert and try to conduct your
own research and invest in individual companies. On the other hand, the secret
to growing rich in the stock market is investing over the long term in a well
diversified portfolio and never trying to time the market.”
Loretta continues, “Consider
this fact: If you were to invest the same way as the average of all investors
then your returns have to be identical to the market’s average returns for that
period. It’s that simple. That’s exactly what investing in broad indexed funds
like the S&P 500 is all about. They are designed to track with the market”
Loretta hands you a glossy
tri-fold pamphlet entitled “Financial Planning: Birth to Retirement” and dives
into her firm’s new Pre-Funding at Birth Trust Fund sales pitch.
“We believe that average
stock market returns over the long-term, say thirty years or more, will always
trend toward their 10.4% historic average. Because of that belief, we are able
to guarantee you a fixed 9.4% return per year. This allows us to keep any
amounts above the 9.4% rate.”
“How this works is; my firm
will invest your $2000 in a trust fund that we set up for Janey. At the end of
each year we automatically add 9.4% to her beginning of the year balance
regardless of how the stock market performed for that year. We assume all the
risk for the 9.4%. Our reward for assuming that risk is we keep any growth over
the 9.4. In other words, if the market averages 10.4% like we believe, then we
will on average profit 1% per year and as your balance grows over time so will
our 1%.
“However, and this is very
important. The money is not available to you or Janey or anyone else until she
reaches age 70.”
You interrupt Loretta “How
much will $2000 at 9.4% per year be in 70 years?”
“Excellent question, let’s
see.” Your lawyer pulls up a Microsoft Excel spreadsheet. In an open cell she
employs the standard future value of a single-sum investment formula. But since
you’re not interested in how she gets the number you stare out her window and
wait for her answer.
=FV(Rate, Nper, PMT, PV, Type) where
FV = Future value which is what we are trying to
obtain.
Rate = Growth rate so she enters 9.4% per year
(0.094)
Nper = The number of periods so she enters 70 years
(70)
PMT = Payment Amount each period or since there are
none she enters 0
PV = Present Value of the lump sum amount. Since it
is rcvd now it’s -$2000
Loretta reclaims your
attention and points to the answer she bolded on her monitor: $1,077,067
Your eyes bug-out of your
head as you blurt out “One million dollars; are you kidding me?”
“I’m not kidding you” says your
new best friend Loretta the Lawyer. “But be careful because in 70 years a
million dollars won’t buy nearly as much as it does today. What we need to find
out now is just how much $1 million will buy in 70 years.”
Loretta drones on “The
Social Security Administration uses 2.8% per year for all of its long term
inflation projections so that’s what we use.”
Reaching for the Excel
application again, Loretta tells you that she will “use the Present Value
function to compute the present value of a future value.”
“Whoa, whoa wait a minute.”
You say. “I have no idea what you just said.”
“Ok” says Loretta, let me
show you. “After 70 years, Jane’s account will be worth $1,077,068. But you
want to know how much that will purchase 70 years from now. The $1,077,068 is a
future amount. To figure out how much it will purchase 70 years in the future,
we have to remove the estimated inflation rate of 2.8% per year. We do that by
converting the future dollars back to present dollars by merely eliminating the
inflation rate.”
“Here’s the formula.” You
notice a pale green hummingbird hovering by a red and yellow feeder outside the
window.
=PV(Rate, Nper, PMT, FV, Type) where
PV = Present value which is what we are trying to
obtain.
Rate = In this case it’s the inflation rate per year
of 2.8% (.028)
Nper = The number of periods so she enters 70 years
(70)
PMT = Payment Amt each period but since there are
none, she enters 0
FV = Future Value amount. $1,077,067
Loretta politely clears her
throat to recapture your focus and points to the Excel answer: $155,856
While pointing to the
answer, she explains “This amount means that a one-time investment of $2000
today that grows at 9.4% per year for 70 years will grow to $1,077,067 but will
only have the purchasing power equal to $155,856 in today’s dollars. Does that
make sense?”
You consider what she said
for a moment and say “Yes, I think so. You’re saying that since the price of an
average house is about $150,000; that my little $2000 gift to baby Jane today will
buy her a retirement house when the time comes. Is that about right?”
“That’s exactly right
assuming that housing inflation averages 2.8% per year.”
Loretta adds, “When Janey
reaches 70, then the second phase of the plan takes over.”
“The second phase?”
“Yes, on Jane’s 70th
birthday, we annuitize her account balance and begin to pay Janey a scheduled
monthly income for the rest of her life. The remaining account balance will
continue to earn 9.4% growth per year. By scheduled I mean, based on the then
current life expectancy for a 70 year old female, we compute the first year’s
annual amount and then divide by twelve to get the monthly amount. Each year we
add 2.8% to the previous year’s amount to protect Janey from expected
inflation. If Janey lives exactly to her expected life at age 70 then her
account balance will reach exactly zero. If she outlives her balance, we will
still continue to pay her at the scheduled rate, including inflation, for the
rest of her life. That guarantee for life is the risk the annuity firm assumes.
On the other hand, if there is any balance in her account when she passes, that
balance goes to the annuity firm.”
“So how much will she get
each month and what’s that worth in today’s dollars?”
“Hey, you’re getting pretty
good at this. Let’s see.”
Again, using Excel, Loretta
computes the monthly annuity payments in both future and present dollars.
Seeing your confusion, Loretta
continues “Your initial $2000 could actually grow to provide lifetime benefits
that will exceed Social Security benefits. Do you want to see what I mean?”
“Whoa, whoa, now you’re
telling me that my $2000 will be worth more to Janey then than her Social
Security benefits?”
“Exactly!”
You agree to see the
computations and Loretta shows you the following spreadsheet.
All amounts are shown in current dollars
|
Begin Age
|
Year
|
Begin Balance
|
Annual Payment
|
Begin Balance
Less Annual Payment
|
End Balance= (BegBal-Payment *
1.094) + 1/2 payment * .094
|
Next year payment = Payment + .028
(Inflation)
|
|
70
|
1
|
$155,856.00
|
$14,650.00
|
$141,206.00
|
$155,167.91
|
$15,060.20
|
|
71
|
2
|
$155,167.91
|
$15,060.20
|
$140,107.71
|
$153,985.67
|
$15,481.89
|
|
72
|
3
|
$153,985.67
|
$15,481.89
|
$138,503.78
|
$152,250.79
|
$15,915.38
|
|
73
|
4
|
$152,250.79
|
$15,915.38
|
$136,335.41
|
$149,898.96
|
$16,361.01
|
|
74
|
5
|
$149,898.96
|
$16,361.01
|
$133,537.95
|
$146,859.49
|
$16,819.12
|
|
75
|
6
|
$146,859.49
|
$16,819.12
|
$130,040.37
|
$143,054.66
|
$17,290.05
|
|
76
|
7
|
$143,054.66
|
$17,290.05
|
$125,764.61
|
$138,399.11
|
$17,774.17
|
|
77
|
8
|
$138,399.11
|
$17,774.17
|
$120,624.94
|
$132,799.07
|
$18,271.85
|
|
78
|
9
|
$132,799.07
|
$18,271.85
|
$114,527.22
|
$126,151.56
|
$18,783.46
|
|
79
|
10
|
$126,151.56
|
$18,783.46
|
$107,368.09
|
$118,343.52
|
$19,309.40
|
|
80
|
11
|
$118,343.52
|
$19,309.40
|
$99,034.12
|
$109,250.87
|
$19,850.06
|
|
81
|
12
|
$109,250.87
|
$19,850.06
|
$89,400.80
|
$98,737.43
|
$20,405.86
|
|
82
|
13
|
$98,737.43
|
$20,405.86
|
$78,331.57
|
$86,653.81
|
$20,977.23
|
|
83
|
14
|
$86,653.81
|
$20,977.23
|
$65,676.58
|
$72,836.11
|
$21,564.59
|
|
84
|
15
|
$72,836.11
|
$21,564.59
|
$51,271.52
|
$57,104.58
|
$22,168.40
|
|
85
|
16
|
$57,104.58
|
$22,168.40
|
$34,936.18
|
$39,262.09
|
$22,789.11
|
|
86
|
17
|
$39,262.09
|
$22,789.11
|
$16,472.98
|
$19,092.53
|
$23,427.21
|
|
87
|
18
|
$19,092.53
|
$23,427.21
|
-$4,334.68
|
-$3,641.07
|
$24,083.17
|
|
88
|
19
|
-$3,641.07
|
$24,083.17
|
-$27,724.24
|
-$29,198.41
|
$24,757.50
|
|
89
|
20
|
-$29,198.41
|
$24,757.50
|
-$53,955.91
|
-$57,864.16
|
$25,450.71
|
|
90
|
21
|
-$57,864.16
|
$25,450.71
|
-$83,314.87
|
-$89,950.29
|
$26,163.33
|
|
91
|
22
|
-$89,950.29
|
$26,163.33
|
-$116,113.62
|
-$125,798.62
|
$26,895.90
|
|
92
|
23
|
-$125,798.62
|
$26,895.90
|
-$152,694.52
|
-$165,783.70
|
$27,648.99
|
“First of all” Loretta
explains, “since we have converted the future amounts to present values, we
will continue to work with present values because it’s easier to visualize the
purchasing power using today’s dollars then future dollars.”
Reviewing the first line of
the chart with you, Loretta explains “When Janey reaches age 70; the plan will
automatically convert the $155,856 balance to an annuity. This annuity plan computes
Jane’s first annual benefit as 9.4% of the beginning balance. ($155,856 X 9.4%)
= $14,650. That’s how much purchasing power Janey will receive her 70th
year.”
Loretta is quick to add,
“This is slightly more purchasing power then the average Social Security
benefit for 2012.”[5]
She continues “The payment
will be made in twelve equal monthly installments over the year. The account
will continue to grow at 9.4% on any unpaid balances. At the end of the first
year after paying the $14,650 to Jane and adding in the 9.4% interest, the
ending balance will be $155,167.91.”
“The last column shows how
much Janey can expect the following year. It’s just the previous year’s payment
amount plus another 2.8% to cover inflation.”
"Each year, payments are
increased 2.8% and paid from Little Jane’s annuity balance until the balance is
exhausted during her 87th year” Loretta points to the line for age 87 showing
that the ending balance goes negative in that year.
Loretta sums the annual
payment column until age 87 less the overdraw amount that year to show you that
if baby Janey lives until her account balance runs out, she will have received
$332,564 in today’s dollars all from your $2000 investment.
“If Jane outlives her
balance, the insurance portion of the plan continues to pay the inflation
adjusted amount for her entire life.”
“When Janey dies, whenever
she dies, if there is any balance in her account, that amount is forfeited to
the firm.”
Loretta emphasizes “The
purchasing power of the benefit is greater than the average paid by Social
Security. She concludes by explaining that $2000 invested today will produce
greater benefits for your child then Social Security is projected to do if
Social Security had the money to pay its promised benefits; which it doesn’t;
and it accomplishes this at a fraction of the cost.
She shows you a chart from
the Urban.org that indicates that the average wage earner contributes over $299,000
in payroll taxes over the course of their working career just for Social
Security but only gets $200,000 back in benefits.[6]
Compare that to the $2000 you could invest today to return $332,564 in today
dollar benefits.
Loretta says “For Social
Security they’ll take out $299,000 over your career and you’ll only get back
two thirds of what you put in. Sounds like a lousy deal to me. What an
incredible waste of money compared to pre-funding with $2000 for life. That’s
the power of compounding.”
“Well yes” you say “But the
government couldn’t do that for everyone. It would cost a fortune; right?”
“Not at all” Loretta says.
“In fact, it would be much cheaper and would be a huge shot in the arm for our
struggling economy.”
“How so?”
Loretta pulls out some
stats. “According to the Bureau of Labor Statistics, about four million
Americans are born each year. If the Fed invested $2000 for each newborn it
would cost about $8 billion a year.
That’s about how much we spend a month in Afghanistan. We would still have to
figure out how to pay the shortfall for those of us alive today under the old
system but all future generations would be secured and as current system
beneficiaries start to pass-on, the problem would start to shrink instead of
continuing to grow.”
“Want more? Back in 2009,
the last year everyone paid all their Social Security taxes, the system
collected $805 billion. Half of that came from our employers and the other half
from the employees. That year, Social Security paid out $680 billion in
benefits. That left $125 billion in surplus that was supposed to be used to pay
the future Social Security shortages. Today, surpluses that have been accumulated
over the years total $2.6 trillion in the Social Security Trust Fund. This $2.6
trillion Trust Fund represents money that workers and their employers have paid
into Social Security to help pay future Social Security benefits. But Congress
has spent the entire $2.6 trillion on stuff not related to Social Security.
Now, Congress will have to borrow another $2.6 trillion or raise more taxes to
pay for the Social Security benefits that have already been paid.”
Loretta continues “If
Congress had just taken the $125 billion from 2009 and invested it at an average
of 9.4% per year, then the gain in an average year would be $11.75 billion
($125 billion X .094). That would be enough to fund a national pre-funding
Social Security program for the next 75 years even with expected inflation and
population growth. In bad stock market years, the excess in the fund would
cover the shortfall. In good stock market years, the fund could be replenished.”
“Want still more? If we
started today, the pre-funded accounts wouldn’t have any obligations for 70
years and by definition the first account couldn’t go negative for 87 years. During
that time, some people with accounts will die youg. What should happen with the
balances in their account? Well we know we have to keep some of the surplus to
pay for those folks who will live past their 87th year beginning in
87 years from now. But the money needed for that obligation will be a tiny
fraction of the total surplus available, what should we do with all the rest?”
“I give up, tell me” you
say.
“Assuming that the taxpayer
funded the initial account, when the beneficiary dies, we can dedicate the surplus
to the shortfall estimated for the beneficiaries under the current Social
Security program. In so doing, we could eliminate the entire $20.5 trillion
Social Security shortfall in less than 40 years. Unfortunately, because our
government has waited so long to fix the problem, Congress would still need to
borrow for several years in order to pay full benefits – but not nearly as much
and only for a few years.”
“Over the long term, pre-funding
would eliminate the current Social Security shortfall; allow Social Security to
become self-funding; eliminate payroll taxes for Social Security and cover all
Americans equally regardless of work history.”
“To the extent we can approximate
how much the average American will need in 70 years to cover their medical
expenses, which CMS.gov does all the time, we can do the exact same thing for funding
Medicare with roughly another $2000 per birth.”
“That’s how Congress should
solve our Senior Entitlement problems.”
“Now let me get to work and
set up this trust for baby Jane.”
[1] November 26th,
2012 Wall Street Journal
As of the most recent Trustees' report in April, the net
present value of the unfunded liability of Medicare was $42.8 trillion. The
comparable balance sheet liability for Social Security is $20.5 trillion.
[3] 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.
Page 50
of the report states: Gradually Invest 15 percent of Trust Fund Assets in
Equities.
The
government could gradually invest Trust Fund assets in a broad index of equity
market securities, such as the Wilshire 5000.If the Trust Funds’ investments in
equities increased by 1.5 percent a year for 10 years and equity investments
were maintained at 15 percent thereafter, it would reduce the long-range
deficit by about 14 percent, or 0.27 percent of taxable payroll. These
calculations assume that Trust Funds invested in equities earn a constant
nominal 9.4 percent return (or 6.4 percent real return over 2.8 percent
inflation) this is 3.5 percentage points over the expected average yield on
long-term Treasury bonds.
[5]
http://ssa-custhelp.ssa.gov/app/answers/detail/a_id/13/~/average-monthly-social-security-benefit-for-a-retired-worker
