Art in Toronto
The Moral Use of Force


Classical Liberal

I actually had a somewhat similar idea a few years ago, which I wrote up as a paper for a class that I was taking. My idea, however, was to completely replace Social Security, thus eventually replacing one unfunded entitlement with a better, prefunded system. The paper is only the outline of the idea, of course, and is only a few pages long, double spaced. I hope you don't mind if I paste it below. I'd be interested to hear your opinion.

The most powerful force in the universe is compound interest.
–attributed to Albert Einstein

Ethical Issue
Marketing 427

Most people are at least somewhat aware that there is a serious long-term funding problem with Social Security. The so-called Social Security Trust Fund is an accounting gimmick that doesn’t hold any real assets since a bond or an IOU from an entity to itself isn’t an asset. The government cannot fund future liabilities by issuing Treasury Bonds to the Social Security Administration any more than I can make myself rich by writing IOUs to myself. The pay-as-you-go nature of Social Security means that current workers are taxed to pay for benefits for current retirees, but even if one has no ethical problems with this sort of socialism it isn’t sustainable with increasing life spans and smaller generations of workers.
Happily there is a better way to provide an income to retired people. Various countries and even some local governments in the United States have implemented a privatized retirement system that replaces a fictitious trust fund with real financial assets. These plans are self-funding and they generally provide better benefits than non-privatized systems promise, but can’t actually deliver. Most Social Security systems attempt to do two separate tasks: assure a minimum income in retirement to avoid destitution, and replace a portion of a retiree’s previous income to support a similar lifestyle in retirement as when working. My plan addresses the first task of assuring a minimum income in retirement by prefunding a retirement account as early as possible to allow the maximum possible time for compounding to work.
Shortly after each live birth in the country the Federal government would deposit a certain amount of money in an account to be held in trust for the newborn. These funds would compound for 65 years until the individual’s retirement age is reached, when they would be used to provide an income. I have arbitrarily selected a figure of $1000 per month. Remember that this plan is intended only to avoid the possibility of destitution in old age. Other plans such as 401Ks, a “Chile style” retirement system, individual savings, and so forth would provide for the remainder of retirement income. Also note that according to figures I could find online, for 2001 and 2002 the average of all monthly Social Security benefits was $852 and $874, respectively. Couples received an average of $1418 and $1454, and the maximum benefit was $1536 and $1660.
To determine long-term rates of return I looked at the certain mutual funds that have been in existence since the 1920s. All results are from company websites. Adams Express is a closed-end fund; the average annual return on it’s Net Asset Value from 12/31/29 to 12/31/03 is 10.19% (the market price return is very similar). Massachusetts Investors Trust is the very first open-end mutual fund; its return from inception on 3/21/24 to 9/30/05 is 9.26%. Both Adams Express and Massachusetts Investors are orientated to capital gains and invest primarily in stocks. Vanguard Wellington Fund is a growth and income fund investing roughly 60% in stocks and 40% in bonds; it’s average return from 7/1/29 to 9/30/05 is 8.36%.
Since, unfortunately, over long periods of time the effects of inflation also compound, it is necessary to look at inflation adjusted (real) returns. If the long-term average of inflation is roughly 3%, then we can expect a growth portfolio to have very long-term real returns of about 7%, and a growth and income portfolio 5%.
In retirement the accumulated funds would be invested so as to provide a lifetime income (such as an inflation indexed life annuity), but for this illustration I have simply used the present value of $12,000 per year from age 65 to age 95. Thus, using a real rate of return of the growth and income portfolio of 5%, the value at age 65 of 30 years of $12,000 per year payments is just under $200,000. The present value at birth of $200,000 at age 65 is only $8400.
Things get even better if we use some different assumptions. Rather than purchasing a life annuity, thus insuring that no principle is left over for heirs, at age 65 the portfolio is invested about 1/3 in cash equivalents, 1/3 in bonds, and 1/3 in equities. The assets with the lowest volatility (the cash and bonds) are spent down first, including the principle. This buys time for the most volatile but also highest returning asset, the stocks, to smooth out the bumps and get long-term average returns. For a full discussion of this strategy see Raymond J. Lucia’s Buckets of Money: How to Retire in Comfort and Safety. This strategy is likely to continue generating income indefinitely, and has the advantage that once the retiree dies there is likely to be a principle amount left that can be passed on to heirs. We’ll assume that the real rate of return on this blended portfolio is 3%. At that rate of return the present value at age 65 of 30 years of $12,000 income is just under $250,000.
Now assume that from birth to age 55 the portfolio is invested for growth and gets an average real rate of return of 7%, and from age 55 to 65 is invested for growth and income and has real returns of 5%. With these rates of return the present value at birth of $250,000 at age 65 is only $3715!
According to government websites, in 2002 and 2003 there were over 4 million births in the United States. If we round that $3715 figure to $4000, then the government would have to deposit in individual trusts about $16 billion each year to prefund the retirement of all native born citizens. In terms of the Federal government’s annual budget, this is a pittance!
Following the principle of individual responsibility, I would prefer that each individual fund their own retirement. Thus, if the Federal government issues $4000 in 30 year Treasury Bonds to fund each newborn’s individual retirement trust, each newborn owes Uncle Sam four grand; the interest on this debt would be the interest rate the U.S. has to pay on the bond. This debt could be paid back any number of ways. Anyone would be allowed to make gifts to an individual’s “retirement debt account” to pay down the principle. Thus, parents, relatives, churches, charities, et cetera could all contribute on a voluntary basis. Individuals would contribute periodically to pay down this debt, and all income tax returns would be diverted to this account until the debt is paid. At age 30, when the long Treasury matures, any remaining balance would become due and the individual would have to refinance the debt or be subject to the government’s usual collection procedures. In practice it might be necessary to implement a small additional payroll tax for individuals under age 30. If the balance of the “retirement debt account” has been brought to zero, this payroll tax would be refundable on the 1040 return.
To illustrate how this might work, let’s use myself as an example. If we assume the interest rate for Treasuries issued when I was born is 6%, and we further assume that my parents made a payment for me of $50 per month, then my “retirement debt” would be paid off before my 9th birthday.
Assume now that no one makes any payments on my behalf, and that I start to make payments of $50 per month from age 18 to age 26, then payments of $100 per month thereafter, and that all my Federal income tax returns are diverted to pay down my account. At age 30 my account balance is <$7101.44> and I have to refinance this debt. If I get a personal loan from my credit union at 10% and continue making $100 per month payments, plus using my income tax returns then I would have the debt paid off when I’m 38.
Some might have a problem with the different outcomes involved with paying back the money the government has fronted each individual, but my goal with this plan is not to achieve equality of outcomes, but to empower each individual to take care of himself or herself without being a burden on future generations.
This is, of course, only an outline of my idea, not a complete plan, but here are some further thoughts.
Taxation: Since, presumably, the “retirement debt” was paid off using income that has already been taxed once, the monthly payments to the retiree should be tax free, like a Roth IRA.
There will be individuals who cannot make payments on their account due to physical or mental handicap, incarceration, et cetera. It should be possible to purchase private disability insurance that would pay off any remaining balance for a small lump payment premium that could be worked into the initial retirement debt account. Otherwise, if charity is needed, let private, voluntary charity deal with it.
Some method will be needed to incorporate legal immigrants into this plan. For a country with negligible immigration, such as Japan, would likely be trivial. For a country with high immigration such as the United States, or say, Canada, this is a more significant problem.
The same principles discussed in this plan could be applied to Medicare, and possibly other government entitlement programs.

Isaac Schrödinger

Your idea is certainly better than what the current system outputs. The problem isn't with ideas but with the practical nature of implementation. Simply put: Politicians get votes from mostly older adults. So, the interests of the generations to follow take a back seat. Today, most adults and politicians don't care that we'll be hitting the limit of this grand Ponzi scheme called Social Security.

I wouldn't trust the government with any retirement money. I'm assuming that I'll be getting zilch for my pension in Canada 40+ years down the road. I should be responsible for my own retirement and that I think is the best prescription.

Classical Liberal

You're right, of course, that it is better for individuals to be responsible for themselves, and that current government run plans are both unreliable for today's workers and are designed to gain the votes of older voters. I didn't actually think any such plan has a snowball's chance in hell of passing.

On the other hand, from what I've read, Chile had an even greater unfunded liability in its pension plans (as a percentage of GDP), and they managed to implement a prefunded system. On still another hand, Chile was an undemocratic dictatorship at the time. :-(

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