How We Can Keep from Going Broke, Part II

As noted in our previous post, Social Security, Medicare, Medicaid and other social insurance programs are bankrupting America. They will produce ever-escalating deficits for as far as the eye can see.

Is there an alternative to all of this that is politically practical? In particular, is there a way to solve our problems so that everybody comes out a winner instead of a loser? Let’s be clear about what we mean by everyone else being better off. Social Security and Medicare have huge unfunded liabilities that carry with them implicit burdens for future taxpayers.

Yet there are tens of thousands of high-income retirees who would do just fine without Social Security or Medicare benefits. Shouldn’t we consider whether they could find a way to exit the system and leave taxpayers with a lower burden than they had before? And why limit ourselves to the wealthy? There is a more general principle here: Anytime anyone — rich or poor — can find a way to solve the social problems Social Security and Medicare were designed to address and leave the taxpayers with a smaller burden in the process, we should welcome the change.

Yeah, I thought I’d saved some but, you know, it’s funny
There’s too much month at the end of the money

Why Win/Win Opportunities Exist. Our entitlement programs involve a stream of taxes and a stream of benefits. Take Bill Gates. Looking forward, he can expect a steady stream of payroll tax payments for as long as he earns wages. What if he made a lump sum payment today in order to avoid all future payroll taxes? Would that be good for him? Would it be good for the rest of us? On the benefit side, what if we could offer him a lump sum amount today in return for his forgoing any future Social Security or Medicare benefits?

If we conclude that there is an opportunity for a win/win deal to be struck with Gates, could similar deals be struck with everybody else? There are at least four reasons to believe so.

Differences in Discount Rates. When the Social Security and Medicare Trustees calculate the unfunded liabilities in those two programs, they discount future taxes and future benefits at a rate of interest equal to the federal government’s long-term borrowing rate. Historically that has been about 3 percent. But when individuals borrow, they typically pay a much higher rate. Some people, for example are paying double-digit rates on credit card debt. If individuals evaluate Social Security’s promised benefits at a higher discount rate than the government (on behalf of taxpayers) uses, then they will place a lower value on those benefits.

Take a man who has just reached retirement age and has a life expectancy of about 20 more years. If he evaluates his expected Social Security benefits using a discount rate of, say, 6 percent, he will value a 20-year stream of expected benefits at about 60 percent of the cost to the government. If the retiree’s discount rate is 9 percent, he will value the benefits at only one-third of its cost to the government.

Continuing with that last example, let’s say the government offers the retiree a lump sum, upfront cash payment equal to half the present value of his expected future benefits (evaluated at a 3 percent real rate of interest). Since the offered sum is substantially more than the value the retiree places on the income stream it will replace (evaluated at 9 percent), the retiree is much better off. And the government will have cut its liability in half!

Differences in Portfolios. One reason people will have different attitudes toward Social Security income streams is that their other assets may be different. Indeed, some people have a private annuity or a government pension. If these assets are viewed as highly secure, a rational individual might wish to trade in his Social Security income stream for investments that would round out a more diversified portfolio.

Differences in Attitudes Toward Economic Risk. Looking back over a long period of time, the stock market has always paid a higher return than the bond market. For example, over the whole of the 20th century, the stock market generated a real rate of return more than twice that of the bond market (6.4 percent versus 2.48 percent). Moreover, there was never a 35-year period in which stocks failed to outperform bonds. In some particular years, however, investors were better off if they were invested in bonds.

Different people respond differently to this information, however. If you have a reasonable tolerance for risk, you will be the kind of person who wants to get out of bonds and into stocks in making long-term retirement decisions. If you have strong risk aversion, you will have the opposite preference.

One way to think about Social Security is to see it as similar to a government bond. It’s not actually a bond. You can’t buy or sell Social Security benefits; and future Congresses can renege on Social Security promises without creating the kind of financial crisis that would ensue if the Treasury failed to pay interest on U.S. government debt. Still, Social Security promises are promises of the U.S. government. In the short run, the right to receive a Social Security check is just as secure as the right to receive interest on a Treasury bill.

Now suppose we gave people the opportunity to get out of Social Security and into investments that carry a higher risk, but also promise a higher return. Some people would pay for that privilege, just as some people would pay for the opportunity to get out of an investment in government bonds and into other assets.

Of course, in the long run Social Security isn’t very safe at all, because of its huge unfunded liability. But that may create another win/win opportunity.

Differences in Attitudes Toward Political Risk. More than 90 percent of all lawsuits are settled without ever going to trial. The reason: most people are risk averse, especially when it comes to something as variable and hard to predict as jury verdicts. Parties to lawsuits are willing to settle for less than they think they may have gotten in court because they are willing to “pay” something to avoid uncertainty. A similar principle may apply to the looming battle over what to do about elderly entitlement programs. Interested parties may be willing to settle for less than they might have gotten simply to avoid the uncertainty over what some future Congress might do.

Clearly, we have promised what we cannot afford. But how confident are you about how you will personally fare when politicians are forced to change these systems? What if you received an offer to forgo future benefits in return for a cash settlement today? Just as parties to a lawsuit may find it in their self-interest to make an agreement today in order to avoid an uncertain future outcome, everyone who has a stake in our elderly entitlement systems may come to a similar conclusion.

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