How to Save Social Security and Medicare

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
http://online.wsj.com/article/SB10001424127887323353204578127374039087636.html
 
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.
 
[2] Americans United Party: Job Policy – Eliminate the Job Burden. http://americansunitedparty.blogspot.com/2011/06/eliminate-job-burden-and-they-will-come.html
 
[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.
 
[4] http://www.aging.senate.gov/ss/ssreport2010.pdf
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
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