Monday, May 30, 2011

Sancho Panza on Social Security and similar private sectorplans

Sancho Panza, the illiterate but clever and witty sidekick of Don Quixote, has a few comments and questions about our Social Security and related programs.
We call it Social Security Insurance, but it doesn't insure.
We call the payments into the program "contributions", but they sure look like taxes.
We talk about funding, but there's no fund.

We talk about earned benefits, but from whom did we earn them, if not ourselves?
So why do have Social Security Insurance anyway, and more importantly, why do we call it what it isn't?
Why don't individuals simply contribute to their own 401k or IRA and skip the entire Social Security complexity? In other words, why not allow an opt out feature?
But if I'm not permitted to opt out and am required to pay taxes into Social Security by my elected political representatives, for whatever reason, good or bad, why can't I get some clear and simple explanation as to why it is good for me, or if it's not good for me individually, then what portion of my "contributions" go to help my fellow citizens, and why it's good for them and our country, too?
Let's now briefly compare the main features of Social Security and private sector pension plans.
Private sector pension plans are funded on an ongoing basis and have clear and explicit actuarial assumptions about how much the periodically funded amounts are expected to earn over time, thus creating an available pool of money which can be used at old age to pay retirees monthly benefits until death. Annuities offered by insurance companies follow the same formula. The benefits are defined. Hence, we call them defined benefits plans. The corporate sponsor or insurance company, as the case may be, assumes the risk of having adequate growth in the fund to provide the benefits promised to the plan participants.

With respect to public pensions for public employees and Social Security recipients, the taxpayer takes 100% of the underfunding or investment risk that monies won't be sufficient to pay the promised benefits upon retirement. The individual benefit is guaranteed by the taxpayer regardless of the fund's investment return or funding amounts over time. The taxpayer is the guarantor.
Let's now contrast these defined benefit plans with defined contribution plans, commonly (but not exclusively) found in the private sector. In these plans, the contributions are made, but the expected benefits aren't guaranteed or even promised. Not by anyone.

An IRA or 401k is an example of such a "defined contribution" plan. An amount is paid into an individual's account from time to time (by either the plan sponsor, the individual or by both) and then is invested at the direction of the individual over time. The investment risk is borne completely by the individual participant, since only the contribution is defined. Investment results over time are added to the periodic contributions and then paid out at old age until death or until the money runs out, whichever first occurs.
In essence, unlike defined contribution plans, the Social Security defined benefit for current retirees is to be guaranteed by a future generation of taxpayers through their "forced or taxed contributions". The prior generations also gave themselves an out to not fully fund their future benefits at the time they voted themselves those guarantees. While they made "contributions" during their working lives, they could therefore be unconcerned about what happened to those payments after they were made. That's because their benefits were to be guaranteed by future taxpayers. That's our Social Security "insurnce" program.

We the people tend to look at the social security benefits as something we have earned and which becomes our entitlement or right, even though its payment is entirely dependent upon the willingness and ability of future taxpayers to make good on what prior generations have voted for themselves. Simply put, the old folks create rights or entitlements for themselves when they are young and at the same time create responsibilities for the future generations to make good on those rights through the payment of required future taxes to fund the guaranteed benefits.

Pancho doesn't understand either the fairness or the logic of that. Neither do I.

Defined contribution plans, to repeat, confer no such guaranteed payment rights.

That's probably why people today are painfully aware of the status of their individual IRA or 401k accounts, while those people with pensions guaranteed by government plans (public employees largely along with Social Security recipients, as examples) need not be so concerned.
Neither does Sancho see either the the fairness of that one. Nor do I.
So Pancho asks, "Why don't we take care of ourselves without government Social Security"? Good question. It would be a simple thing to do if we followed a few simple steps or habits.
Earnings and then saving a portion thereof, or living within our means, is a habit. Investing is a habit which results from the habit of saving.
When we earn, we either spend less than we earn, spend exactly what we earn, or spend more than we earn. Thus, other than the exactly what we earn scenario, we either generate savings or debt. If we save, we then are able to invest those savings.

As we save and invest, we have an opportunity to learn about the wonderful world of compound interest, the rule of 72 (which will be discussed in a later note) and a secure financial future for ourselves and our family.

If instead of saving and investing a portion of our earnings we choose to borrow, we will have to make interest payments on the debt incurred, and we will then have to begin to save more than we spend if we ever hope to repay that debt. Otherwise the horrible world of compounding will apply to the debt we've assumed.
We have to stop digging the hole of accumulated debt, in other words, if we ever want to get out of the hole we're digging and enter the world of saving and investing. It's harder this way, but it's also better late than never.
This compounding from savings joy or borrowing sorrow all starts for each of us at a relatively early age. Student loans, credit cards, car loans, home loans and many other loans are all out there for the taking. And they are habit forming as well, just like saving and investing are.
Sancho wonders if "We the People" and our government are ready, eager and willing to learn about hole digging, changing our deeply entrenched habits about debt and then following all this up by acquiring the joys of compound interest. So do I.
But he hopes we are. So do I.

Thanks. Bob.

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