Social Security: Reform, Refund or Opt-out? (Part 2)

Public Pension Concepts and Alternatives

Social Security reform combines three basic possibilities. It can raise contributions or it can cut benefits sometime in the present or future (pre-funding or pay-as-you-go (PAYG)). It can be private or public. It can be diversified or undiversified. The current system is public, has no diversification and is not pre-funded (PAYG). It features forced savings in that income cannot be spent before retirement. It pools social risk so that it can provide insurance against earnings loss, disability, inflation, and longevity. It redistributes income from high to low lifetime earners. The Social Security System is controlled and administered by the U.S. government and is a defined-benefit plan (DBP) .
“Pre-funding” is a plan to reduce the sum of the system’s implicit and explicit debt. As alluded to previously in the discussion of the vulgar error, the current system has inherited or legacy debt. This is something many politicians either willfully forget or ignorantly omit. Any analysis and reform must include provisions for the cost of inherited debt or it is a truly disingenuous and misleading discussion. Omitting taking care of this unfunded liability (which is estimated at around $10 trillion) is the vulgar error committed by the many politicians who compare returns from strictly switching to other assets. They do not mention deducting this debt from the alternate assets’ internal rates of returns (IRRs) to the IRRs of Social Security. The IRRs of the Social Security Trust fund for future generations account for the legacy debt.
The earliest cohorts received very high IRRs in real terms. An anecdotal and extreme example is that of my grandfather who worked for the Federal Reserve System which did not become part of the social security system until six months before his retirement in the mid 1960s. He actually deferred his retirement six months to buy into the social security system and qualify for benefits. He, and for awhile my grandmother, received nearly 15 years of monthly benefits for six months of his contributions. A truly amazing IRR and one for which his progeny will be paying for years to come.

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