During the next six to twelve months, we can be sure we will be exposed to a huge amount of passionate advertising both in favor of the President's proposals regarding Social Security and against them. My only prediction is that we aren't likely to see a lot of unbiased truth on either side of the argument.

For at least the last 50 years, a substantial majority of Americans have assumed that their projected Social Security benefits would be an integral and predictable part of their retirement income. Financial planners have devised investment plans based on the assumption that Social Security benefits were reasonably predictable. Only a few people were willing to defy conventional wisdom and argue that the Social Security system was on a collision course with defaulting on the promised benefits. Numerous elite panels of experts have been given the task of studying the problem and all of them have basically recommended solutions that merely deferred the time of reckoning. It has become political conventional wisdom that any federal politician who proposes any reduction or delay in Social Security benefits will not be re-elected.

In his State of the Union message on February 2, 2005, President Bush tried to stimulate a serious dialog about the extent of the problem and about various ways to solve the problem. Instead of a rational dialog, I see the early signs of a verbal war between the supporters of the status quo and those who believe that serious change needs to be made now.

When you entrust some of your money to an insurance company in exchange for a promise of a future amount of annual annuity benefits, your primary risk is that the company might go bankrupt. There is virtually no risk that the insurance company will change the terms of the contract. Even if the company does go bankrupt, the National Association of Insurance Commissioners will assign the contracts to other solvent insurance companies and will assess the other insurance companies to share the cost of any loss of benefits to the policyholder.

With the federal government, default is not an option except through bankruptcy of the currency (hyper-inflation). Instead, if the government is unable to raise enough taxes to pay the benefits that have been promised, they will unilaterally change the terms of the deal. With only the consent of a majority of our elected representatives, they can reduce future benefits, raise taxes, delay the age at which benefits begin, borrow to pay benefits or employ some combination of these options. In fact, this has been done to a limited extent.

The retirement age for receipt of full benefits is already scheduled to increase to age 67. Taxes have been raised over the years by raising the tax rate from 2% (1% for the employer and employee) in 1937 to 12.4% in 2005. The amount of earnings subject to the social security tax has increased from $3,000 in 1937 to $90,000 in 2005. A portion of the benefits received are subject to income taxes, depending on the taxable income of the recipient. For some recipients, 50% of the benefits are taxable. For others, 85% is subject to income taxes. In many states, taxable Social Security benefits are also subject to state income taxes. Starting in the year 2000, employees over the age of 65 could receive full retirement benefits. Previously, there was a reduction in benefits of $1 for each $3 of earned income for those from the age of 65 through 69. This change was adopted to encourage more people over age 65 to continue working. (I suspect the real reason was to make it easier to increase the age at which future benefits will be paid when that becomes necessary.) Many of these tax increases have been justified because of increases in benefits. One of the most costly of the benefit increases was the indexing of benefits to inflation.

In spite of the increased benefits, the tax increases have resulted in a substantial annual surplus of Social Security taxes collected in excess of current benefits paid. These surpluses have been dutifully recorded as increases in the Social Security Trust Fund -- and have then been promptly loaned to the Federal Government General Fund to help pay for general account deficits. Annual surpluses are projected to continue through the year 2012 or 2018 -- a mere seven to thirteen years from now.

That's when it will be necessary to make some hard choices about paying those who are retired and the baby boomers that will begin retiring at about the same time.

Alternative Solutions

I've been arguing with various people for nearly 20 years about the so-called Social Security Trust Fund. My argument is and has been that the money is gone because it has been borrowed by the general fund and spent. In order to repay the amounts that are owed to the Trust Fund by the General Fund, the government will have to

(1) have a general account surplus sufficient to pay all the benefits that have been promised,
(2) borrow from other sources such as foreign lenders,
(3) raise taxes,
(4) cut benefits to retirees,
(5) increase the age at which full benefits are paid -- or
(6) employ some combination of these options.

Another option that hasn't been mentioned recently was proposed by Harry Browne, the Libertarian Candidate for President in 1996 and 2000. He proposed (among many other changes) that the government simply sell some of its huge amount of land and other kinds of property and use that money to pay off the current retirees and those over age 50.

An even more extreme solution is discussed at the end of this article.

If the government borrows the money at any required rate of interest, that will result in higher rates of inflation. Thus, retirees may get all the benefits promised to them, but the money they receive will be worth less and less in terms of purchasing power. The result is the same as a cut in benefits.

The AARP and others who don't want to change the status quo are arguing that the government will be able to repay the Trust Fund when the Social Security taxes collected are less than the amounts owed to retirees. However, the opponents of reform are more than a little bit vague as to how 2.5 or 3 workers will be able to pay enough taxes for current general account spending, to fund their own retirement and to also repay the Trust Fund to provide benefits for their retired parents. Whether you believe the Social Security system is bankrupt now, is going to be bankrupt in the year 2012 to 2018 or will never be bankrupt depends on your faith in the ability and willingness of working Americans to continue to pay more and more into a system that will be paying back less and less.

Trends in Benefits and Contributions

Social Security benefits have been decreasing in relation to living costs and I anticipate this will continue and will accelerate dramatically after the year 2012 or 2018.

My mother and mother-in-law both received social security benefits that were far in excess of the amounts that were contributed on their behalf -- even taking into account a very generous return on investment. Both of them were able to pay for 100% of their living costs for many years with their Social Security benefits. My wife and I started drawing benefits recently and the amounts we are receiving are significantly less than our modest living costs. Unlike our parents, we will not be able to live in comfort on our Social Security alone -- even with a paid off home. And, the projected returns on the taxes we have paid are far below the return for the taxes paid by our parents generation. Our children are about 25 years away from retirement and it now seems absolutely certain that any benefits they might receive will be reduced if their income exceeds some arbitrary amount and that the return on the taxes they will pay will be negative.

My wife and I are continuing to work and are saving nearly all of our Social Security benefits -- after deducting the income taxes we have to pay on those benefits. If we don't have to spend years in a nursing home, we will be able to leave some of that money to our children to help repay them for the excessive social security taxes they will have to pay.

When asked, I advise my clients not to plan on receiving all the Social Security benefits  projected by the Social Security actuaries. When you start projecting income or expenses more than ten years in the future, a very small change in the assumed rate of investment income or inflation can have a huge impact on the numbers. My own approach to financial planning is to maintain a modest lifestyle and to continue to save as much as I can -- which is nearly all of the Social Security benefits we are now receiving.

And I fear that our kids will get far less from the Social Security system than my wife and I are likely to receive. They will be stuck with having to pay for some of our generations retirement benefits while also trying to pay into the system for their own retirement. But it is what they think that counts and I perceive that few of their generation expect to get enough from Social Security to repay what they will have to contribute. That means they will have little incentive to continue to contribute and will look for opportunities to reduce the Social Security taxes they have to pay. I expect them to pursue a variety of legal ways to avoid having to pay that tax. Some of them will shift into real estate investing and others will use S corporations to reduce their Social Security tax. Some will do business as a taxable corporation and will pay themselves a dividend subject to a 15% or less income tax rate in order to avoid the Social Security self employment tax. A few may even expatriate. And a lot of them will simply start to do work as an independent contractor 0ff-the-books and won't pay any taxes on that income. Even a modest change in the form of looking for loopholes to avoid paying the tax can have a large impact over a period of ten to twenty years. Long term government forecasts are not able to accurately consider the impact of a change in the behavior of the citizens or those affected by changes in various government benefits or taxes.

To some extent, an offer to privatize part of their contributions would help to give them more incentive to participate in the Social Security system. Without such an incentive, we should expect many of the younger workers to look for ways to alter the nature of their income so they can reduce the amount of Social Security taxes they must pay.

Many commentators on this subject argue that the over 50 members of our society are the most likely to vote and that they will vote against any changes in Social Security. However, there are still at least two younger workers for each retired person and eventually they will vote in favor of change.  It is just a question of when.

If Not Now; When?

Is Social Security in a crisis right now? Probably not for ten or fifteen years, depending on how optimistic you are about the US economy during that period of time. Does it need fixing right now? The sooner we face up to the problem and adopt some solutions, the less painful the transition will be. The longer we wait, the greater the pain. If we don't fix it, it will fix itself by forcing the government to reduce benefits, to increase taxes or to increase government debt and inflation. If we wait too long, it will become a means based system where benefits are only available for those who don't have any other means of support.

What about the claims that allowing younger workers to divert some of their benefits into a private account will cause an additional $1 trillion in deficits? This number has been bandied about in various articles but when I tried to locate the source, it turned out to be an article in the MotherJones.com web site -- with a link to the web site of Prospect.org. However, the article in www.prospect.org stated that privatization would increase the deficit by $2 trillion. While some commentators call the shortfall a deficit, the two sources mentioned both indicated that it represented the additional cost of funding retiree benefits. A deficit by definition is an annual cost which increases the federal debt, which is an accumulation of the annual deficits.

At this point, it is not clear whether the claim of an additional $1 or $2 trillion dollars is based on projected benefits without reducing the benefits of those who elect to privatize part of their accounts. Such projections can only be done by the actuaries who have all the data and computer programs that make the Social Security projections. Clearly, if a taxpayer chooses to divert up to 1/3 of the total 12.4% of tax contributions to a private account, future benefits to that person would also be reduced. But, because the taxes collected for Social Security are not really being used for Social Security, there will be less of an annual Social Security surplus to loan to the general account and to spend on a host of government programs. Thus, the general account will have to find that money elsewhere -- by borrowing or by raising taxes or by cutting various programs. The alleged deficit will not be in the Social Security account but in the General account.

Thus, the real argument about deficits being caused by privatization is about cuts in other government spending or increases in taxes or borrowing to make up for the shortfall that will be available to borrow from the Social Security account.

Whatever impact the change may have on the annual deficit and the accumulated debt, I can't help but be a bit amused at the sudden change on the part of the Democrats and Liberals regarding fiscal responsibility. All of a sudden, the political parties seem have to have switched roles regarding their concern for the growing national debt -- both on and off the books.

Conflicting Views

But to me, the real bottom line is whether the government should be responsible to take care of us from cradle to grave. I don't favor that point of view, but I suspect that a majority of voters in this country at this time would be fearful of losing their varied government benefits -- such as Social Security, unemployment benefits, Medicare, Medicaid, agriculture subsidies, art subsidies, education subsidies and the salaries of millions of federal workers and state or local workers who receive substantial federal funding. Each group will lobby intensively to protect their benefits. Logically, they would be prepared to spend up to $1 to protect $1 of benefits for their programs. A little bit of that money will go to lobbyists and to advertising media. A lot of that money will go into the campaign coffers of a lot of politicians.

The Feb. 9, 2005 issue of USA Today reported the results of a survey regarding how the respondents felt about various methods of solving the Social Security problem. The results were very predictable in that all but a few taxpayers will prefer to have someone else pay to fix the problem. About 2/3 of the respondents favored limiting benefits for wealthy retirees and imposing Social Security taxes on all wages and self employment income without limit. Roughly 1/3 of the respondents favored reducing benefits further for early retirees, increasing the rate of tax imposed on all wages, raising the age at which full benefits could be received and reducing benefits for those below the age of 55. Meanwhile, the February, 2005 issue of the AARP Bulletin includes a feature article on the disadvantages of privatization. On the other side of the issue, the Cato Institute has compiled a large collection of articles and studies about the Social Security problem and the Presidents proposals. 

The argument has barely begun and we can expect to be subjected to a barrage of deceptive or misleading claims about various proposals to fix the problem.

Since I won't have any opportunity to affect the outcome of this issue, my wife and I propose to make plans for our own retirement security by maintaining a modest lifestyle, living in a paid off home, continuing to work as long as we can, doing everything we can to protect our health as long as possible and by saving as much of our Social Security benefits and other income for as long as we can. I do not plan to waste any of our money trying to lobby any politicians in support of any political solution to the problem. As stated at the beginning of this article, my only prediction is that we aren't likely to see a lot of unbiased truth on either side of the argument. Nor do I think we will see any kind of politically courageous solution. But I hope I am wrong on both counts.

A Controversial Alternative

Since I wrote the first part of this article I've received a few comments to the effect of "How would I prefer to solve the problem"? 

I'm extremely suspicious of how the government will attempt to control the so-called private accounts in order to protect younger participants from themselves. The owner of an auto painting business who established a retirement plan for his employees told me that most of his workers would quit their job after a couple of years in order to cash in their retirement account -- even though they had to pay taxes and penalties on the withdrawal.  It seems virtually certain that any kind of private account will end up subject to extreme restrictions in order to prevent people from taking the money and spending it on medical bills or such extravagances as food. And of course, there is the concern that some of the private account participants would withdraw the money in their account and use it for an assortment of things like a newer car, liquor or drugs. To prevent that, the government would have to impose and enforce such extreme restrictions that most participants would conclude that the accounts were not any more private than simply staying in the existing Social Security system.

If we are going to have private accounts, let's make them genuinely private by not imposing another government bureaucracy to oversee the use of the private accounts. Why not just give the younger participants the right to put a part of their Social Security taxes into their IRA or other tax qualified retirement plan?

However, this would cause many people to object on the presumption that many participants would withdraw and consume their retirement funds and would be dependent on society when they were unable to work. My solution to that problem is just as extreme and unlikely to garner any support. I believe that Social Security should eventually be a source of subsistence income for those are unable to work and who have not saved enough money to support themselves. It would provide a minimum level of support close to the poverty level and would be funded by income taxes. Barring other solutions, this is the ultimate consequence of not doing anything to fix the problem.

From a political perspective, it is inconceivable that a gradual change to a system like that would survive the constant change in the power shifts between Democrats and Republicans -- a/k/a liberals and conservatives. But if those in control of government policy don't implement some kind of gradual change to shift from an unfunded government pension system to a funded private pension system, the laws of economics will produce a solution that will be even more extreme than my suggestion.

Vernon Jacobs

About the Author:

Vernon Jacobs has been a financial and tax author for over 30 years. He is a CPA and Chartered Life underwriter and Fellow of the Life Management Institute. He was a senior financial executive for a substantial life and health insurance company for 12 years and has written and lectured extensively on a variety of tax, financial and legal issues. He is a board member, the Treasurer and the webmaster for Positive Lights, Inc. -- a public charity committed to discover and communicate best practices in the care of the elderly and disabled. His web sites include www.vernonjacobs.com and www.positivelights.org


Reference Links:

Cato institute - http://www.socialsecurity.org/

AARP - http://www.aarp.org/socialsecurity

MotherJone.com - http://www.motherjones.com/news/dailymojo/2004/08/08_518.html

The American Prospect - http://www.prospect.org/print/V13/17/diamond-p.html

USA Today - http://www.usatoday.com/printedition/news/20050209/1a_lede09_dom.art.htm
(This link might be a temporary link)
 

Vernon Jacobs is the Editor/Publisher of the International Wealth Protection Monitor, an email newsletter about how to legally protect your assets from excessive lawsuit judgments in the U.S. A free "e-book" on the subject is available at http://www.offshorepress.com/protection  Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa