by Keith Weiner, Sprott Money:
We have been writing about capital destruction. This week let’s look at an event which is currently making news. Social Security will begin tapping into its trust fund this year . This happens, as the Social Security Board of Trustees states antiseptically, “four years earlier than projected in last year’s report.” In other words, the economy is growing by every conventional measure, yet Social Security is spending more than its tax revenues years earlier than projected. According to those same inaccurate projections, the trust fund won’t run dry until 2034.
Everyone opines on Social Security. Some, like Max Richman of The Hill , claim that, “modest and manageable measures…” will, “keep Social Security solvent.” Others, like Charles Blahous at the Manhattan Institute , say the opposite, it’s “bad and getting worse.”
There are several aspects to this that are worth understanding. We will unpack this mess.
A Defined Benefit Pension
Let’s start with a look at a proper defined-benefit pension program. It works by setting aside a portion of workers’ wages into an investment fund. Based on actuarial tables, they know that if an employee works from age 21 through 65, he will live on average X years in retirement. Based on long-term market data, they know that the fund can expect to earn a yield of Y% per annum. Therefore, they can calculate a stipend to pay the worker in his retirement.
It should be noted that this stipend becomes worthless, sooner or later, in an irredeemable paper currency regime. That’s because the currency is constantly eroding. What begins as a reasonable monthly income, shrinks into insignificance as the currency loses value.
Pensions responded to this problem by offering annual cost of living adjustments (COLAs). Unfortunately, the COLA is an impossible promise. That’s because the universe does not guarantee that investment returns shall exceed increases in the cost of living due to the falling dollar. As we have written several times, there are also nonmonetary forces pushing up prices such as taxes, regulations, litigation, zoning, licenses, compliance, etc. Investment returns do not increase, whenever these costs are rising (likely the opposite).
The problem of investment returns insufficient to match rising cost-of-living becomes acute, when interest rates are falling, such as we have had since 1981. That’s because a pension fund invests assets to earn a yield, to earn interest. And the central bank induces a continual drop in interest rates.
Next, a properly-run pension cannot be “spiked”. It cannot pay workers based on their salary for their last few working years, especially if they cram lots of overtime. The stipend paid over the length of retirement has to be based on the salary deductions over a lifetime of working, and the age of retirement.
Needless to say, a proper pension cannot add new beneficiaries late in their careers. Indeed, it cannot make any new promises to anyone. It can only invest to earn the returns predicted up front, and only pay workers the pensions calculated up front.
Note that earning a yield—interest—is key to the whole thing. Interest is earned during the years the employee is working, while he is setting aside money from his salary. And it is also earned during his retirement.
There must be a strict accounting of funds for each worker. The only pooling of funds is for an actuarial purpose. Some workers may die before retiring. Others may die soon after they stop working. But others will live much longer, with a few continuing to collect payments for 35 years or more of retirement. They are all pooled, so the fund averages the outcomes of all workers.
The pension fund is expected to draw down its balance as its retirees age. It should not be designed to run out of money and default on living retirees. Nor should it have a big surplus left over after the workers all die.
Falling Interest Erodes Pension Funds
So much for a properly-run pension fund. Pension fund managers understand something that few, other than readers of this Report, understand. The falling interest rate erodes the capital of the fund. They are falling shorter and shorter. We assume that they despair of ever trying to explain this to workers and retirees. The politics, not to mention optics, would be against them.
The unacknowledged truth is that with each drop in interest rates, there must be cuts in actual and promised benefits. Or else the amount taken from workers or their employer must go up.
Needless to say, this doesn’t happen nearly as often as it should. Even most private pensions are insolvent. They cannot continue to pay what they promised, without running out of money before all retirees die. The pension fund is consuming its capital at a faster rate than the actuaries calculated. Retirees will suffer losses, perhaps the total loss of their monthly checks, depending on how the pension manager responds to the crisis.
A private fund has a limited means to reach out and take money from innocent third parties. If the fund is insufficient to meet the needs of current retirees, it can’t really get that much from young workers. These workers have a choice, they can simply switch jobs to avoid this tax.
The Social Security Ponzi Scheme
Enter, Social Security (SS). SS is not run as described above. Let’s look at the key differences. First, there is no way to opt out. So young workers are forced to subsidize current retirees.
Second, promises to pay benefits are made without consideration to setting aside the beneficiaries’ money first. SS is very big. It seems that big things, especially big government things, can be used as slush funds to make promises in exchange for votes. And no one complains until their benefit is defaulted (by which time it will be far too late).
Next, SS is explicitly designed to be pay-as-you-go. That is, current workers are paying for current retirees. There is a giant switcheroo being pulled here. On the one hand, everyone who reaches the age of retirement thinks that he has “paid in.” And yet everyone who is working is paying out! Their money is not going in to a fund (or not all of it). It is going to current beneficiaries. In exchange for this blatant rip-off, they are promised to be paid later. Paid how? By taxing the next generations, some of whom haven’t even been born yet.
Our focus in this article, as all articles, is on the economics. But we must pause here to say it. SS is a moral outrage.