Why Social Security Is the Best Retirement Saving Vehicle

Josh Barro is the lead writer for the Ticker, Bloomberg View's blog on economics, finance and politics. His primary areas of interest include tax and fiscal policy, state and local government, and planning and land use.
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Last week I wrote that Social Security is the healthiest component of the U.S.'s retirement saving system and should therefore be expanded. This isn't a popular position; liberals tend to prefer defined-benefit pensions from employers and conservatives defined-contribution accounts, such as 401(k)s and individual retirement accounts. But the reason Social Security works so well is that it lacks a fundamental problem that undermines the effectiveness of these other retirement vehicles.

Both defined-benefit pensions and defined-contribution accounts are based on a shared and problematic premise: It is possible to set aside x percent of today's gross domestic product for retirement and generate retirement income from those savings that exceeds x percent of future GDP. This is to be achieved by investing retirement savings in assets that typically grow at a faster rate than the economy as a whole.

Such returns are possible. Some asset classes have long-run rates of return that exceed GDP growth: equities, for example. But the high returns are a compensation procyclical risk: These assets will tend to strongly outperform GDP when the economy does well and significantly underperform it during recessions.

It doesn't make sense to finance retirement in such a risky way. Retirement savings exist disproportionately for the benefit of people with low or moderate means and a relatively low tolerance for risk. If retirement assets were invested safely, they would not be expected to grow faster than the economy as a whole.

So 401(k) and traditional pensions are both just efforts to finance retirement on the cheap by taking on excessive risk. The problem created by risk manifests itself in different ways with the different vehicles.

With 401(k)s and IRAs, retirees tend to invest in equity-heavy portfolios and then get hammered if they have bad luck in the stock market. This leaves retirees with far less wealth than they expected, needing to work longer or significantly lower their standard of living. Even worse, recessions that reduce the value of retirement assets will also tend to hit wage income and home equity.

The risk situation with pensions is more complicated because pension payouts to retirees are guaranteed regardless of the plan's performance. But just because investment risk is taken off the retiree does not mean that it goes away. In the case of a corporate pension, investment risk is shifted to the employer; for public employee pensions, the risk goes to the government and taxpayers.

Laws over the last four decades have made private-sector pensions more secure, but in doing so such laws have also increased the apparent costs of pensions. Private employers must calculate such costs on the basis of the risk borne by the employee; they cannot write down the cost because they expect high returns on risky investments.

That is, private pensions no longer rely on the premise that retirement can be made cheaper through investment in assets that grow faster than GDP. But such a free lunch was what made the plans attractive for employers in the first place, and as employers have faced the plans' real costs, they have increasingly eliminated them.

In the public sector, the free lunch lives on in the financial statements of pension funds. Governments fund their pensions based on an expected rate of return on a risky portfolio of assets, most commonly between 7.5 and 8 percent a year, far above the roughly 5 percent growth path we might expect for nominal GDP.

When fund assets underperform, taxpayers must make up the difference. In essence, governments are writing insurance policies to their employees that pay out when the market does badly and collect when it does well. This is not a "win some, lose some" situation, because a government's overall fiscal fortunes are closely correlated to the investments pension funds make. The windfalls will come when they are least needed and the excess costs when they are least affordable. In the past few years, required pension contributions have spiked at the same time that state and local governments faced other fiscal distress.

The mistaken idea that we should finance retirement with especially risky investments has led to major errors with both types of retirement vehicles. With individual accounts, people undersave in part because of the expectation that small equity investments upfront will produce big retirement income due to high returns. With government pensions, politicians overpromise on benefits because part of the cost is hidden.

Social Security is also based on a bet about future economic performance, but it's a much more reasonable bet. Forget the trust fund -- Social Security is based on a bet that the payroll tax base and annual benefit payouts grow at approximately the same pace.

In practice, that's not quite happening: As the share of the working-age population shrinks, the growth of benefits is outpacing the growth of taxable wages. But funding gaps in Social Security open up much more slowly than in pension funds and 401(k)s. The roughly 16 percent funding gap we must close in Social Security over the next 75 years is easily manageable compared with shortfalls in public employee pension plans and the woeful insufficiency of 401(k) balances: just $42,000 for the typical middle-income retiree.

Oddly, one of the top virtues of Social Security is that it is unfunded. When there is a pool of money sitting around to finance retirement liabilities, there is always a temptation to chase yield, because if you can achieve a high return, you don't need to set aside as many assets.

But Social Security isn't any ordinary unfunded liability. In most cases, an unfunded liability is an even bigger invitation to mischief than a funded one. Although pension funding rules allow politicians to understate the cost of benefits, not prefunding at all can allow them to treat the cost of providing benefits as zero. This is how state and local governments have found themselves under more than a trillion dollars of health-care liabilities to retirees, far more than they ever realized they were promising.

Social Security stays unfunded and sustainable because of two of its other features: It is universal, and it has a dedicated tax source. If an unfunded benefit grows to have a surprisingly large cost, but it only covers a small share of the population, the government is likely to end up simply passing that cost along to taxpayers. That's hard to do if almost everyone is a participant. Social Security's universality gives politicians an incentive not to overpromise and individuals an incentive not to overdemand.

Although Social Security could theoretically be financed through general revenue (and was, in part, during the payroll tax holiday in 2011 and 2012), there is strong political pressure to ensure that Federal Insurance Contributions Act tax revenue and benefits paid stay in line over the long term. This means that any major benefit increase would have to be accompanied by a FICA tax increase, ensuring that benefits do not rise above a level that is fiscally and politically sustainable.

So what is the policy upshot? One option, as I argued last week, is to expand Social Security to finance a larger share of retirement costs. Another option is to transform defined benefit and defined contribution systems so they mimic Social Security's virtues: That is, they would invest in lower-risk assets expected to grow roughly in line with GDP or wages and not chase yield by taking on excess risk.

For example, I discussed last week the possibility of adding mandatory savings accounts to Social Security. These shouldn't be 401(k)-style accounts that might be invested entirely in equities. Instead, at least for people with low and moderate incomes, these savings should be invested in assets that produce lower but more secure returns. They could even go into specially created government securities that pay a yield linked to GDP or wage growth.

All of these options (expanding Social Security or downshifting the risk in other investment vehicles) would cause retirement saving to appear to become more expensive. But it wouldn't actually make saving more expensive: It would just replace hidden costs created by risk with explicit costs.

Americans would then face a stark reality: Retirement, which is basically just another word for spending the final sixth of your life on vacation, is expensive. I am agnostic on the question of whether people ought to respond by saving more or retiring later. Advocates of later retirement tend to be elite people with jobs that are interesting and not physically demanding. But facing up to the true cost of adequate retirement saving would help Americans make more sound choices about how to deal with the fact that retirement is expensive.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.