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Economics: The Future of Social Security
New York: February 07, 2005
By John R. Stephenson

Last week, U.S. President George W. Bush outlined his vision for the next four years of his administration. One central feature of his platform, other than to spread democracy around the world, is the partial privatization of Social Security. The basics of the Bush plan are to create a series of private retirement accounts that would allow workers to invest a portion of their payroll taxes in private assets and accumulate returns on their investments - in short, the system would become partially privatized. This proposed change, if adopted, would be a step toward a guaranteed contribution system and away from a guaranteed benefit system. The real question is: does social security need fixing and, if so, what are the implications for investors?

Social Security is a creation of Franklin Roosevelt's new deal era and is basically a government welfare program to help people in their old age. As a welfare program, it is not intended to be a retirement program like a 401k but rather it is a transfer of wealth from one group to another - without a means test. Of course, when the plan was conceived back in the 1930's, the average life expectancy was only 60 years of age (Social Security benefits kick in at 65) as opposed to today when the average American should live to a little above 77. Today, with people living longer, there is real concern about the ability of government to make good on all the pledges that they've made, including Social Security - with good reason.

Within the next ten years, the spending on the elderly in the U.S. will total $1.8 trillion or almost half of the federal budget (according to a survey by the Brookings Institution and the Congressional Budget Office). The bulk of this spending is on Medicare and Medicaid, the government's two largest health care programs, with Social Security spending rising from $492 billion to $882 billion as the first wave of baby boomers starts to retire in 2008. The sad truth is that, as a nation, we have made promises that we just can't keep. If we were to pay for all of the currently promised entitlement programs from tax increases alone, taxes would have to rise to 33% of GDP by 2040 as calculated by the Center for Strategic and International Studies. This high level of taxation would decimate all economic growth and would result in increased unemployment. Of course, spending could be cut on parks, research and education instead of a massive tax hike, however, under that scheme the elderly would receive some 56% of all national expenditures.

If you think the problem is bad in America, consider what is happening in Europe. High taxes and an aging population are creating huge burdens on European society. Just last week, the German Federal Labor Office in Nuremberg reported that unemployment jumped some 573,000 to 5.037 million, the highest level of unemployment (11.4% of the population) since Hitler came to power in 1933. This is coupled with a sluggish economic growth of only 1.6%. If tax increases were chosen to support all the promises made by European governments for entitlement programs, taxes world need to rise to over 50% of GDP in every single country and France would see taxes rise to 62% of GDP. In short, we have made promises that we, or our children, just can't keep. The promises were sustainable when there were 15 workers for every retiree but as we approach two workers or even one worker per retiree, these promises are just unsustainable (see figure 1). The only answer to this problem is to cut benefits or raise taxes or a combination of both.

Figure1: Elderly Dependency Ratio

Social Security is a looming problem and a key fiscal imbalance for the U.S. that must be dealt with. The combined federal, state and local budget gaps (deficits) account for 4.4% of GDP with the Federal Government owing the lion's share (85%). Today, Social Security stands at a cash surplus of 0.7% of GDP but should experience a cash deficit by 2018. Social Security, while a major problem, is nothing in comparison to the looming crisis in health care with both Medicare and Medicaid in serious trouble (It costs six times as much to look after a retiree as it does an infant). If the problems of Social Security can't be solved, there is little hope of tackling the problems with the healthcare system. While it would be wrong to ask current retirees and people close to retirement to accept a change, a new system should be implemented that will align more closely with the current realities.

Giving workers between the ages of 25 and 54 the option to contribute between 2-6% of their taxable earnings up to a maximum of $1,000 to $5,000 annually towards personal accounts is a good first step. There are precedents for the use of private accounts and they are encouraging. In Chile, which privatized their retirement system in 1980, they discovered that the change encouraged higher income households to boost savings by more than 2% of GDP. This could well be the case if the U.S. were willing to make such a change. While there is no immediate crisis in Social Security, there is a looming one - as retirement benefits start to grow faster than wages and payroll taxes which will further increase the likelihood of enormous government budget deficits. One step that could be taken, in conjunction with private accounts, would be to boost the retirement age to 70 and then indexing it for rising life expectancy - a change that if implemented today would more than halve the current government deficit.

While a shift away from government spending on Social Security to a system of private accounts has little immediate economic benefit (since the pool of savings would likely remain constant), it does set the stage for further reforms to the system of entitlements that has existed for the last seventy years. Under the proposed Social Security reforms, the Bush administration is proposing borrowing some $2 trillion to set up these private accounts. But in a nation that already owes $8 trillion, and will have to borrow the money anyway, if we don't act this might be a small price to pay in the long run. If private accounts were adopted, private savings rates would likely edge up over time which, while a detriment for retailers in the short-run, the higher level of savings and investment could spur long-term economic growth as those savings look for a home in which to be invested.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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