Month: February 2015
Social Security – part 2
¿Hay Problema?
So if you understood the math and reasoning of my last post you may be asking, so what’s the problem? Why do people worry about SS or presume it may not be around for their own retirement? Does the SS fund really have problems?
Yes and no.
The American Academy of Actuaries (AAA) released a public statement last month which was addressed to President Obama and Congress the morning before the State of the Union address. In it, Academy President Mary Miller calls on US lawmakers to focus on the solvency concerns of US Social Security as well as US Medicare. The AAA is concerned that the aging population and the large influx of baby-boomers will strain the system if no changes are made. And they are correct. The system cannot continue to function the way it always has if more and more people are receiving SS and less are paying into it.
Similarly, Steve Goss, Chief Actuary of US Social Security recently did a reddit AMA (a very casual interview where he answers questions from anyone on the internet that cares to submit them) in which he said the fund would be insolvent as early as 2033 if no changes were made to the current legislation. However, he also stated, rather confidently, that SS will be around for a long, long time. Based on current projections, without legislative action the fund can function as it does today until 2033, and at that point would still pay out $0.77 for every $1 paid in. Thus, the concern that SS will disappear completely is unfounded.
Keep in mind that SS is largely a political issue. My opinion is that because it affects so many Americans (particularly the elderly who tend to be more likely to vote), the debates arise around election time to stir up controversy and candidates use this hot topic to make a political statement.
Why SS Needs to Change
If the population were to stay static over time, there would be no issue with the current Social Security legislation and funding. However, a couple of large shifts in the US population are going to put a major strain on the funds if no legislative action takes place.
Longer life – the advances in medicine, nutrition and medical care over the last 50 years have led to significantly longer life expectancies. By most accounts, this is a good thing. For the health of the SS fund, this is a bad thing. This means those that are retired are receiving more paychecks instead of doing the patriotic thing and, ahem, passing on.
Baby Boomers – check out this graph. This says it all. Ever since the late 40’s, birth rates have fallen and then flattened out in the US. Those baby boomers are starting to retire and have just now started receiving Social Security checks. They are also leaving the workforce, i.e. have stopped paying SS taxes. It’s not that complicated, less people paying into the fund, more people pulling money out of the fund, funds get depleted.
Possible Solutions
If you find at the end of the month, every month, that you just can’t pay your bills, what do you do? Simple. Well, mathematically it is simple. You either go out and earn more money or cut back on your expenses. Same works here. Solution one is to raise taxes. If everyone working paid slightly more than the current 6.2% rate into the Social Security fund, the problem would be solved.
The next solution is to cut benefits. If everyone currently receiving SS checks suddenly got a smaller check, or, if people couldn’t start drawing SS until a later age, the taxes coming in would be enough to cover the benefits paid out.
The third solution is to do nothing. Considering the first two options, you can see why any politician would be slow to suggest them. You are going to upset someone or a lot of someones with either raising taxes or cutting SS benefits. This is why Congress’ solution for about the last 25 years has been to do nothing. I’m not saying it is a good solution, but no one is willing to make that jump. As I mentioned earlier, doing nothing will really not affect anyone financially for the next 15 to 20 years.
Recommendation
If you read my post last year about Health Care Reform, you may be hoping I have some cool solution to solving Social Security. I’m afraid the solution here, however, is not all that cool, it’s really simple. We either let the fund die, we raise taxes or we drop benefits. Some reading this blog may be a fan of raising taxes, I am not one. By default, that means I think SS could be saved by lowering benefits. There is a (somewhat) politically correct way to do this, however. You can’t just lower the paychecks right now of those receiving SS. You would have to phase the change in. Something like this: those born after 1970 cannot begin receiving SS until age 63, those born after 1971 can’t draw until age 64 and so on until the Gen Y and Millenials are waiting until 70 to draw SS. This way those that are affected wouldn’t have been retiring for another 20-30 years anyway so they have time to save and prepare.
The reason this makes sense is because life expectancies and quality of life at advanced years is better now than it has ever been. Many in their 60’s and 70’s are still working today because they are fully capable of doing so and with more and more people living into their 90’s, they will still have time to enjoy a long retirement.
If you don’t want to work into your 70’s, well, save more now or prepare yourself to live off of less when you retire. A cultural shift needs to occur in the US towards saving, in my opinion. By almost any measurement, US households just don’t save as much of their paycheck as those in other countries. We should not be saving what we have left over, but spending what we have left over after saving. Anyway, there’s my solution, you asked for it. Time will tell what the real solution for solving SS will be, we’ll know in at-most 18 years. Thanks for reading.
Social Security – part 1
Social Security is a fascinating and somewhat controversial actuarial topic. In this month’s posts I plan to give some general background around what is Social Security and how actuaries play a major role in its success or failure.
History/Background of Social Security
Social Security has been around a long time, it’s hard to imagine our country without it. But think for a second, what did retired people do before Social Security existed? They didn’t. Retire, that is. The concept of retirement was invented in the late 19th century with the first pensions. Most people just worked until they died or couldn’t work anymore. Social Security came into play as a way to care for the elderly and disabled who could not work.
The Social Security Act was signed by Franklin D. Roosevelt in 1935 in the wake of the Great Depression. It was the first federal assistance program signed into law. Before 1935, anyone that was unable to work would have to rely solely on family or charities to provide for them. Since the act was passed, there have been dozens of additions and changes to US Social Security including setting the payment amount on a cost of living index, adding Medicare, broadening the scope of coverage to include the disabled and children from low income families, and several rounds of increasing taxes to fund the program.
Today, the retiree benefit side of SS is run much like a big communal savings account. Everyone earning an income is taxed 6.2% of their earnings for SS and these funds keep the program going. At any point after age 62 you can decide to start receiving SS funds. It’s like forcing everyone to save for retirement. The major difference between SS and you saving for retirement yourself is that the taxes taken from your check today are spent on retirees today. There is no individual account you can see which tells you how much you’ve contributed to SS and thus, how much you will have in that account when you retire. This leads some to fear that SS could shrivel up and disappear before they retire, leaving them up a creek. We’ll discuss this a little later.
Types of Retirement Plans
The actuarial aspect of Social Security has to do with the uncertainty of life. SS guarantees you a monthly check until you die. The total paid out in SS funds for someone’s lifetime could be very little (they die young) or a large sum (those that live longer than average). For the government to sufficiently fund the plan, they need to know how many beneficiaries will get SS and how much they will get, which is the role of the actuary. But before we get into the math, let’s talk about retirement plans in general.
There are two major categories of retirement plans: Defined Benefit (DB) and Defined Contribution (DC). In a DB plan the payout received while retired is preset. That is, when you enter the pension plan, you already know what your payout will be once you retire. Some private companies in the US have DB plans, though they are dying off, and most government jobs have DB plans.
In a Defined Contribution plan, the amount contributed monthly or annually is defined- but not the benefit. You put in a set amount each month or each year and it accrues interest and you just have this big (or small) pot of money when you retire. You don’t know when you start how much you’ll have when you retire because it depends on how much you put in and what kind of return you get on your investments. The most common DC plan is a 401K, which is offered by many of today’s businesses to its employees.
So the real difference between a DB and a DC plan is who takes on the risk. For DB plans, the employer takes on the risk. They are guaranteeing a benefit, regardless of how the stock market and general economy perform. If the economy performs well, they reap the benefits. If the economy tanks, the employer is stuck with providing the same benefit. In a DC plan, the employee takes on all the risk. The employer is simply paying a set amount up front and if the economy does well, the employees’ account grows with the gains in the market, if the economy tanks, it is solely up to the employee to figure out their retirement.
A Mathematical Example
Let’s suppose I work for the State of California. I don’t know what their pension structure looks like but let’s suppose that if I work for the State for 30 years and retire at age 63 I am guaranteed an $8,000 check every month as part of my pension. How does CA know they will have an extra $8K in their monthly budget in 2045? Well, they better start funding the pension now. How much do they put aside now to assure they will have enough to pay my pension in 30 years? In steps an actuary. With mathematical models he/she will take into account several variables to determine how much CA has to set aside today to fund my pension and that of my co-workers in the future. Some key assumptions that are at play here are: retirement age, life expectancy, lapse rate (probability of moving to another job or quitting early), and rate of return on pension fund investments.
You can see from this scenario that a huge amount of risk is being taken on by CA for guaranteeing a pension of $8,000/month. The most sensitive variable in this formula is the interest rate. If the actuary assumes CA can get a 5% annual return on their pension savings fund, they will need to put away roughly $1,800/month now so that in 30 years this will accrue enough interest to pay out $8,000/month. On the other hand, if the actuary uses a more aggressive assumption of 8% annual return, CA only has to put away about $800/month. $1,800 vs $800/month is a huge difference when an employer is offering pension benefits to thousands of employees; that’s millions of dollars every month. In a defined benefit plan, an employer funds the pension using a certain set of assumptions but if those assumptions don’t play out as expected they are still obligated to pay the benefits in the retirement agreement. For this reason, the employer and the pension actuaries will work together regularly to review the assumptions and determine the correct amount to fund.
On the other hand, suppose CA had a defined contribution plan. They take a middle road and contribute $1,300 per month to their employee’s pension fund but put it into a 401K plan. After the initial contribution the employer doesn’t touch it or get involved again. If the account earns 8% annual interest, great, if it earns 5% or less, not their problem. It is up to the employee to contribute more funds and allocate them into the right investments to ensure he/she has enough saved for a happy retirement.
US Social Security is a Defined Benefit
So how does this relate to US Social Security? Does SS work like a DB or DC plan? Are your SS benefits defined already? Actually, yes. The benefits are already defined for each person in the US that has a social security number. In fact, you can go on the SS website right now and use a calculator they have created to estimate what your SS payout will be when you decide to start drawing it. Obviously, your benefit is not as simple as getting a flat $2,000 per month. That wouldn’t be entirely fair. The level of your benefit depends on what age you start receiving it, how much money you’ve made in your career (i.e. how much you’ve paid in taxes toward SS), and other variables.
So play with the calculator and reflect on what life without SS would be like. In my next post we’ll discuss the controversial side of US Social Security and why, if congress continues to do nothing, SS will slowly fade away.
Actuarially Sound 