Could This Be a Low-Cost Fix

for Social Security?

Social Security is in financial trouble

• Social Security’s Trust Funds are on track to empty in 2033. If nothing changes, that will force benefits to be cut by about 23%.

• An average retiree currently gets $1,328 per month. With a 23% cut, that will become an inflation-adjusted $1,022.56.

Source: Social Security 2014 Trustees Report

Over the long haul, the costs are staggering

• $10.6 trillion through 2088.

All hope is not lost

Charts excerpted from Social Security

Despite the challenges, Social Security still has a lot going for it:• Its Trust Funds have nearly $2.8 trillion in them• Its tax and investment income brought in nearly $0.9 trillion last year

So why is there a problem?

Social Security’s Trust Funds are invested very conservatively:• The Trust Funds are entirely in US Treasury bonds• Their rate of return is abysmal – about 3.5%• The investments choose “absolute” certainty over return potential

This is an issue because:• Social Security has a substantial annual inflow from taxes that can

handle most of its benefit payments. It doesn’t need all its assets in ‘high certainty’ investments to make near term payments.

• Social Security’s payment structure includes an annual inflation adjustment, which generally increases payments each year. It needs a higher rate of return to compensate for those higher costs.

What could be done better?

If Social Security’s Trust Funds were invested like a well-managed traditional pension plan, its funding pressure would be reduced.

• Current year’s payments would be paid via tax revenues, cash, and maturing bonds – virtually identical to the current process.

• Next few years’ payments would have a “bond ladder” reserve to cover the expected shortfall from taxes not covering benefits.

• Longer term reserves would be invested in a low-cost broad stock market index such as Vanguard’s Total US Stock ETF (NYSEMKT: VTI).

• The bond ladder reserved would be replenished from interest payments, dividend payments, and liquidating portions of the stock market index investment, as needed.

What’s a Bond Ladder?

Source: pixabay.com

Cash 6-12 months of

expenses

Bonds6-10 years of

expenses

StocksEverything else

A bond ladder is a portfolio structure that holds:• Cash for short term needs,

• Bonds that mature each year for the next several years to replace that cash as it gets spent, and

• Stocks for long term returns and to replenish the top of the bond ladder as those bonds age.

How a pension plan could look at the numbers Social Security’s best estimates for 2015-2023 cash flows look like this:

Social Security’s assets at theend of 2014:$2.8 trillion in US Treasury bonds

Total cash and bond ladder needed to cover 7 years of cash flow gaps: $0.6 trillion

That leaves $2.2 trillion that can be invested for longer term needs

That money has a better shot at decent long-run returns in a diversified stock portfolio than it does in low-interest Treasury bonds .

Projecting out a “pension style” investment plan

Trust Funds in 2033:This plan: $2.4 trillionCurrent Social Security: $0

This wouldn’t “cure” Social Security, but it sure would help…

Key return assumptions:• Cash: No interest, Bonds: 1% interest, Stocks: 9% Returns

Source: Author’s estimates based on information in the 2014 Social Security Trustee Report

What are key challenges to adopting this plan?

Unfortunately, spreadsheets behave differently than financial reality, which would add substantial challenges to adopting this plan.

• Social Security’s current holdings would need to be liquidated: The US government debt held by the Trust Funds would need to be refinanced by the Treasury. That could get very expensive for the government, especially if it happened quickly.

• Social Security’s new investments could not be made quickly: Social Security would dominate trading for a period measured in weeks to months to get its new portfolio in place. That would certainly move the market and put its total return potential at risk.

Not to mention the politics…

On top of the financial concerns come political ones:

• Can Uncle Sam be a neutral owner of company stocks? Stock ownership generally comes with proxy votes. $2 trillion-plus of investment brings with it a lot of potential board room influence.

• Can Uncle Sam stomach a market downturn? The market goes down as well as up. A bad market, particularly early on in the conversion, could cause lawmakers to panic, reverse course, and “sell low”, making Social Security’s position worse than before.

• Can Uncle Sam stay the course in a good market? If the market has another multi-year run, the Trust Funds’ balances could swell. That would create a huge pot of money tempting lawmakers to spend on some other priority.

Still, it’s worth considering

Despite the challenges in adopting a pension-style investment plan for Social Security, it’s still worth considering for these two key reasons:

• It extends the Social Security Trust Funds’ viability by allowing investments with potentially higher returns.

• It reduces the need for higher taxes and/or lower benefitsassociated with Social Security’s traditional patching process.

Millions of Americans are depending on Social Security to fund a substantial portion of their retirements. Doesn’t it just make sense to make changes that give the program a real chance at a better long term future?

Can this Social Security secret boost your retirement income by $60,000?