Over lunch today with a colleague, the we turned to a discussion of how Ford managed to avoid much of the hardship that befell GM and Chrysler. In addition to a design change that refreshed Ford's product range with truly competitive products, Ford took perhaps their boldest, most important action. That action was buying out several workers from their retirement and pension systems.
Headline after headline we see how pension costs and medical costs are breaking the back of state and municipal governments all over the country. Similarly, the defined-benefit pension and retirement systems offered by the "Big Three" were causing them to hemorrhage cash when they most needed it.
At that point, I had a little bit of an epiphany. Would it be possible to reform Social Security by "buying out" Americans from the current system into a cheaper one? At first it seemed possible because of two powerful facts: 1) the rate of return in social security is much worse than even a very conservative investment could produce, and 2) Switching from a defined benefit to a defined contribution plan is one of best ways to lower costs.
What if you could throw a lump sum of money at a working American in return for them choosing not to receive Social Security benefits? They would still pay in at the present rate of (12.4%, divided equally between employer and employee) to support those presently drawing Social Security. But in they would a lump sum representing all their future retirement benefit (discounted to present dollars) in return for forfeiting their claim to SS benefits. Obviously, different amounts for different people would have to be calculated. Let's begin by walking through a scenario for a "nominal person" to see if we could devise a "buyout" that would benefit him and Social Security both.
Bob will turn 65 soon. He started working and paying into SS when he was 25 (year 1972). Let's assume that Bob's pay goes up 2% per year for 40 years, culminating in a 60,000 annual pay in his last working year (age 64).
According to the Social Security Calculator, Bob is now eligible at age 65 for a monthly benefit of $1970, or $23,640 per year. We will quote all dollar figures here in constant dollars that roughly reflect the 2011 value of a dollar.
Over Bob's 40-year working career, he has paid in $185,814 in total SS taxes/contributions on a total lifetime earnings of $1,662,899. The CDC tells us that Bob's life expectancy at present is 78.2 years.
If Bob lives only as long as his 78.2 age expectancy, he will draw benefits for 13 years, and receive $307,320 in SS benefits over his life. In this case, Bob puts in $185k of his own money over his 40yr career and received what amounts to $307K in benefits. Is this a good investment? If Bob had earned an average of 3% on his money, he'd have $314K on the day he retires rather than $307K on the day he dies. Even a paltry THREE PERCENT return give you more money at age 65 than SS would give you with another 13.2 years.
What if Bob had been allowed to put his money into another investment instead? Let's use a super-conservative investment rate of 7%, which many bond mutual funds can deliver. Suddenly, Bob's $185K in contribution is now worth $721,124 the day he retires. Plus he OWNS it, and can pass much of it on to his family (minus estate taxes).
But let's assume for a moment that Bob just invests his earnings in the S&P 500, which has averaged 9.5% per year since 1928 (including all major stock market crashes and the nearly-flat last decade). Now Bob has $1,294,434 at the exact same age when he retires.
While this data is useful to illustrate just awful is the bargain that the public receives off the Social Security retirement system, it is more powerful than that. It lets us literally save Social Security.
Here's how it would work. Depending upon how far along a person is in their working career, they could accept an offer to be bought out. Social Security could have offered a young Bob in 1972 a buyout of $18,840. In accepting this buyout, Bob would agree to keep paying his 12.4% payroll taxes his entire working career, but he would forfeit ALL claim to SS benefits. Why might he accept the Government's offer? He'd accept it because if he invests that $18,840 at a mere 7% return, he retires with the same $307,320 as he would have under Social Security. However, he would have it all as a lump sum of cash instead of monthly checks between retirement age and death. If he gets the 9.5% that the stock market has averaged for almost 90 years, Bob retires with over $700K in a lump sum.
What about Social Security? By offering Bob the cash up front, it spends $18,840 to collect, over Bob's working career, $185,814-- a difference of about $167,000. Because Social Security no longer has to payout benefits to Bob when he retires, Social Security now has a net positive cash flow of $167,000 over Bob's working years.
What if Bob is not at the beginning of his 40 year working career, but right in the middle at 20 years of working? Now, Bob is much closer to retirement, so he will demand a larger buyout to give up that SS benefit. Perhaps Social Security offers Bob $79,420. This lump sum, invested at 7% for the last 20 years of Bob's working career will give him the same $307,320 he could expect in lifetime Social Security benefits-- only give it to him immediately when he retires. Social Security still benefits by over $100,000 as it will take in at least that much more than it paid to Bob.
No matter where Bob is in his working career, there is still a buyout amount that saves Social Security money and benefits Bob-- a rare win/win situation. The basic concept is valid.
True, there are some details that would have to be resolved. For example-- how would you ensure that a person keeps their money invested? The government already penalized early withdrawal of IRAs, so the same method could be applied to thee "buyout" program-- though perhaps with a more severe penalty.
Who wants to participate in the pilot program?