The Real Reason Why Social Security is Going Broke

Social Security

Just about everyone thinks that the upcoming shortfall in the Social Security balance sheet, which will cause it to become bankrupt, is solely because of changing demographics.

The Baby Boomer generation is starting to retire, and this will certainly place a larger and larger load upon the Social Security system, resulting in the amounts paid out exceeding amounts paid in. Once this happens, and the shortfall is sustained, this will see us running the Social Security trust fund down more each year, until it eventually runs out of money.

There’s also the fact that people are living longer these days, and this all adds up to more recipients receiving benefits for longer, which the current system just cannot handle long-term. Current projections have Social Security going broke by 2035, just 16 years from now, if we remain on the same course that we are now.

Social Security gets its revenue from collecting the money that people currently working pay into the system, and pay it out to retirees. Excesses are kept in the trust fund, where they are invested, and the returns on them help sustain the program. There is currently $2.9 trillion in the fund, but the time where this fund will be called upon to help with shortfalls in the system is already upon us, set to start next year.

From there, each year will require another contribution from the trust fund to top things off, until we eventually get to the point where there is no more money left, and without further action, the amount of benefits that can be paid will be limited to the amount that we take in.

As the ratio of the amount of people paying into the system versus the amount receiving benefits becomes reduced further, the deficit will continue to expand. The shortfall per year when we do run out of money therefore isn’t the one we will be seeing next year, it will be where this ends up after this deficit grows for 15 years.

This does not mean, as most people suppose, that their Social Security benefits will be gone by then, as people will still be paying into the system. However, they will have to get by on the amount that gets paid out to them when the annual tax revenue gets divided up. The fact that there will be a deficit tells us that benefits will have to be reduced though, perhaps by a third or so, which is where the thinking is right now on the course that we’re on.

The Real Reason We Got Into This Mess

Demographics can therefore be blamed, although it’s not just Social Security that has to grapple with these more challenging demographics, as this is a big issue with all pension funds. They all operate pretty much the same way, with a pension trust that invests money and is relied upon as a backstop.

The Social Security system that we have today was designed in 1935, and the trust that provides the resource to rely upon when amounts paid out exceed amounts collected was allowed to invest, but only in U.S. treasuries. The S&P 500 had fallen from 465 in 1929 to just 82 in 1932, and while it had climbed back to 170 in January 1935 when Social Security first was rolled out, this was not seen as a market that Social Security trust money should be exposed to due to the risk involved.

The S&P is now near 3,000, and while it has had its ups and downs, we haven’t had to touch this money over all these years, and if there ever was a situation or fund that is suitable to long-term investing, the Social Security trust fund would be it. Other countries allow their state run pension funds to invest in stocks, but we did not, and still do not.

We also knew back then that it would be a very long time before we would have to spend any of this money, so this is certainly a case where the fund could bear any risk that the market could throw at them, including even a repeat of the 1929 crash, which we were well on the road to recovering from in 1935.

It did take a full 40 years for the stock market to get back to where it was in 1929, but this trust fund could afford to wait this long for a recovery, provided that the long-term view remained positive. We might forgive this mistake back then though, because we really were dealing with a U.S. stock market that had a lot less data to work with, and we weren’t anywhere near as confident as we are today about its longer-term upward bias.

The 50’s and 60’s was a boom time for stocks, where the S&P quadrupled in value over these two decades, while the Social Security trust fund stood back and watched and settled for the paltry returns that treasuries paid. The U.S. government didn’t even allow any pension fund to invest in stocks during this time, still thinking that they are not suitable for this purpose.

In 1973, they relented, and pension funds in general were allowed to invest in the stock market for the very first time, although all these years later, Social Security is still bound by the mistaken view that they arrived at back in 1935. This is the real reason behind all the trouble the system finds itself in today.

The Amount of Money We Passed Up On is Simply Enormous

The impact of this decision over time has simply been enormous, not even counting the bullish impact that all this extra money would have had upon stocks over all these years. Stocks go up in value by more people investing in them, and all these extra funds would have driven the market upward in a measurable way. We’re talking about $2.9 trillion here, about 10% of all the money invested in U.S. stocks, and that’s an amount that could have raised stock prices by quite a bit had it been allowed to participate.

The biggest difference would be in what this $2.9 trillion would have been if we had invested it properly, even if we just started in 1973. It is at least somewhat understandable that if the government wasn’t going to allow private pension funds to invest in stocks, they weren’t about to let Social Security to do it, but once they did open up to the idea generally, it did not make sense to exclude the world’s biggest pension fund, one that they are on the hook for should things not work out.

Perhaps they need a few years beyond 1973 to think about this matter more, especially since the 1970’s was a fairly rocky time for stocks. If they had just changed these rules in 1980 though, the fund wouldn’t just be worth $2.9 million, we’d have many times more that amount now.

We wouldn’t even be having conversations like this with that much in the fund, and when we also add in the expected growth of stocks over the next decades, there would be plenty to tide us over for a very long time, to a time that wouldn’t even appear on our radar right now and concerns about the higher load from Baby Boomers would be handled easily.

This opportunity has come and gone though, and we cannot ever recover this massive amount of money that was passed up on, and if we look to implement something like this now, we now have to deal with the risk of a long bear market that may precipitate the trust fund going broke even sooner than it will. It is far more reasonable in fact for them to stick to treasuries now than it ever was, and this would be similar to being able to take on more risk in your earlier years but less when you get close to retirement, and this fund is entering its retirement now and is also nearing its death.

It is therefore not as simple as pointing all of this out and hoping that the rules of investing of this fund move beyond 1935 and into the 21st century or even into the latter quarter of the 20th century. If they throw all this money into stocks now with only a 16-year lease on life, this could be extended, but it could also involve shortening it.

Even though our understanding of stock markets has improved dramatically since the old days, this does include a better understanding of risk as well, something that those who are calling for the limitations of just investing in treasuries to end and have us finally start to do the sensible thing here need to account for.

With the backs of Social Security so much up against the wall, and the government likely continuing to want to use this trust for fiscal purposes, where their treasury purchases limit the need of the government to buy these treasuries to expand the money supply, it’s very unlikely that they will have a change of heart this late into the game.

We will need to do something though, and just cutting benefits is one of the options, but the window on playing the stock market with this trust may have closed prior to this latest bull market. The value of stocks tripled over the last 10 years alone, and this would have provided a real shot in the arm to the fund had it participated in this, and alone could have bought the fund several more decades of life, but this bull market cannot be counted on to deliver another 10 years of this, and might end up giving up a third or more over the next 10 years if things don’t go that great.

Still though, it would at least be interesting if not helpful for things to open up here and see the fund at least put a good amount of their money in stocks, even though their time horizon is very much limited here, and 15 years until bust just isn’t all that long of a time, especially when redemptions will be required every year along the way. Rather than just watch this fund die though, facing a certain death quite soon, it would be nice to see the Social Security trust fund at least try to put up a little fight to survive a little longer in its last years.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: [email protected]treview.com

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