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The Social Security Divide

25 July, 2014

Since its implementation in the 1930s, Social Security has been a financial constant in the lives of Americans, first as taxes assessed against earnings to fund the program, later as a monthly retirement income. Except for some limited exemptions (most of which came at Social Security’s beginning), all Americans participate in Social Security; everyone pays into the program, and everyone qualifies to receive a monthly retirement income.

Social Security is a group plan in which current taxes fund current benefits; even though taxes and benefits are calculated based on individual incomes, Social Security does not keep separate accounts for each future recipient. Although previous tax collections built significant reserves, since 2010 Social Security has run an annual deficit, and the shortfall between the taxes and benefits is increasing. According to its most recent annual report, current tax and benefit rates are projected to exhaust the plan’s assets by 2033.

One of the reasons for the funding gap is the demographic anomaly of the Baby Boom generation, which has distorted the proportional relationship of taxes collected and the number of retirees receiving benefits. Consequently, even though it was intended to be a plan for all Americans, the economic benefits from Social Security project to be sharply divided along generational lines – with some modest winners and big losers.

Stanley Druckenmiller, a retired investment fund manager, is touring college campuses with a presentation titled “Generational Theft.” Druckenmiller’s main premise: Individuals entering the workforce today are participants in a plan that projects to deliver negative benefits in the future while continuing to provide overly-generous benefits to today’s retirees. Putting this idea into numbers, Druckenmiller compares the total payments made into Social Security during one’s working lifetime and contrasts it against benefits received, then makes comparisons for different age groups. In summary, 

“(W)hile today’s 65-year-olds will receive on average net lifetime benefits of $327,400, children born now will suffer net lifetime losses of $420,600 as they struggle to pay the bills of aging Americans.”

This means if you’re currently receiving Social Security or soon will be eligible, it’s a good deal – i.e., benefits received will most likely exceed the taxes paid. But the younger you are, the less attractive Social Security gets, and the Baby Boomers look like the last generation that will truly benefit from a Social Security retirement. For the generations that follow, the program projects to deliver negative value, as least in regard to retirement income.

Is there a fix for this dilemma? Yes…but not really. Druckenmiller says the Baby Boom generation is so large and the benefits they are due to receive will last so long that it is not financially possible to borrow to cover the annual deficits until the population stabilizes. According to Druckenmiller, this leaves two options: “Either tax rates rise, or generosity falls. There is no alternative.” Unfortunately, the unusual funding structure of Social Security makes either option problematic, because workers from different generations have different self-interests.

For example, Druckenmiller proposes a possible fix by subjecting eligibility to means-testing; the more you have in assets and income, the less you receive in Social Security benefits. But 65-year-olds on the cusp of retirement with 40 years of payments to Social Security aren’t likely to see this as a “good deal” or even “fair.” They paid for others’ benefits and were told younger generations would be doing the same for them. Changing the terms of agreement for a large group of Americans just before retirement seems like bad policy – and bad politics. What politician would risk the wrath of a large voting bloc by decreasing benefits?    

On the other hand, once they understand the math, it’s tough to imagine most young workers continuing to support the current arrangement. Where’s the value in paying to sustain someone else’s benefits while losing money yourself? And if the proportion of benefits received to taxes paid is already bad, convincing the public that the problem can be solved by increasing taxes will require serious spin, since an increase in Social Security taxes would affect everyone, not just “the rich.”

A means-testing qualification also changes a fundamental assumption of Social Security. Instead of a program in which all Americans participate and all receive benefits, means-testing will result in some participants paying into the system, yet receiving nothing. This is a circumstance with great potential for antagonism and division between generations and income brackets. Further, means-testing, creates a moral hazard for personal saving. If every dollar saved reduces one’s future benefits, saving becomes counter-productive.  

In considering these issues, no silver-bullet solutions are readily apparent. In fact, given the understandable tendency of politicians to avoid or delay changes to Social Security that might be unpopular with voters, there is perhaps a greater potential for bad endings: an eventual collapse of the Social Security system and loss of benefits, along with an economically stratified and divided country.     

Pragmatic Responses to Inevitable Changes

Twentieth-century economist Herbert Stein’s most famous pronouncement was “If something cannot go on forever, it will stop.” Social Security, as presently configured, will not go on forever, which means eventually it will stop. When this happens, commentators will dissect the reasons, and assign blame. But knowing how it happened and who is responsible will not change the outcome, or the financial impact it will have on individuals. Better to honestly assess one’s options, find opportunities, and attempt to select the best of what may be tough alternatives. Two broad considerations:

Identify your generational position. The cut-off line is fuzzy because everyone’s situation is unique, but in general: The older you are, the more value you can expect from Social Security. As Druckenmiller notes, today’s 65-year-olds are receiving significant value from Social Security retirement checks; workers in their 20s cannot have similar expectations. When it comes to crafting a response to the uncertainties of Social Security, there is truly a generational divide. First-generation recipients of Social Security and the Baby Boomers are on one side. Young people just entering the workforce are on the other. Those between 40 and 60 are on the fence, wondering how things will fall out for them.

Adopt “generationally appropriate” financial strategies. Currently receiving benefits? Gratefully accept every check, and hope the projections for 2033 are wrong – in a good way. Prudence might suggest keeping a reserve accumulation 

(especially if you are a younger retiree), just in case Social Security ends before you do. 

About to retire? The window for determining Social Security retirement benefits opens at age 62 and extends to age 70; the longer you wait, the higher the monthly payment. A number of sophisticated calculators exist to help retirees determine the optimum age at which they should begin drawing benefits. But since the Baby Boomer cohort now moving through this window may be the last to truly benefit from Social Security, there is also an argument for receiving benefits as early as possible, even if the monthly payment is diminished. If government projections are correct, what’s more valuable: receiving a smaller check for 20 years, or waiting for a larger check, but only receiving it for 10?

Between 50 and 62? These are particularly vexing issues, because while Social Security has not yet changed/diminished/ended, the day when it inevitably does is growing closer. Retirement is on the near-horizon, but some once-sure resources may not be available. The potential for means-tested benefits also comes into play. How will this uncertainty affect you? Should you save more? Work longer? Or perhaps retire sooner? These are tough questions, the kind that should prompt serious discussions with your financial professionals.

Below 50? The choices may be clearer, yet more challenging. If nothing changes, you’ll pay more in taxes than the benefits you’ll receive. If a means-test is instituted, those who save will receive even less. The pragmatic but aggravating response is to take Social Security out of your retirement plans. If this is your assumption, the most likely replacement is increased personal saving. Making this happen typically involves forgoing some present enjoyments, i.e., no big vacations, no new cars, not eating out as often, etc. A diminished standard of living is not a psychological positive; at some point, delayed gratification gives diminishing returns.     

          

Relying on one-size-fits-all financial maxims (i.e. save 10%, max your 401(k), etc.) has never been an ideal approach to securing a prosperous future. The demographic realities behind Social Security’s funding issues exaggerate this point: How you plan and save for your financial future is very much impacted by your generational position. Your situation is not the same as that of your parents, or your children. The national challenge of Social Security is unlikely to be addressed proactively because politicians often have strong incentive to “kick the can” to the next generation. But individuals would be well-served to act now, because history shows that demographics can create economic consequences for which there are no quick fixes.