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By Gary D. Halbert
March 9, 2004


1.  Fed Chief Warns Of Social Security Related Deficits.

2.  What You Pay In Is Spent On Others’ Retirement.

3.  Suggested Payroll Tax Increase Does Not Solve Problem.

4.  Timing The Coming Social Security Financial Crisis.

5.  The Realistic Solutions Are Politically Unacceptable.


Two weeks ago, Federal Reserve chairman Alan Greenspan warned Congress that the Social Security system must be reformed or it will lead to a crisis and massive budget deficits in the future.  Greenspan told the House Budget Committee the nation would face “one of the most difficult fiscal situations” in its history as 77 million baby boomers begin retiring around 2008.  “This dramatic demographic change is certain to place enormous demands on our nation's resources - demands we almost surely will be unable to meet unless action is taken.”

Greenspan, who chaired the 1983 federal commission that enacted earlier Social Security reforms, reminded the politicians of the following well-known but routinely rejected solutions: 1) increase Social Security taxes; 2) reduce benefits for future retirees; 3) raise the Social Security retirement age; and 4) use a different inflation index to calculate annual cost-of-living adjustments.

But will any of these reforms be implemented?  Not likely.  Social Security is the so-called “Third Rail” of politics – touch it and you die.  Based on initial comments from President Bush and Democratic presidential nominee John Kerry, nothing is likely to be changed anytime soon.  Shortly after Greenspan’s latest comments, Bush said that Social Security benefits “should not be changed for people at or near retirement.”  Senator Kerry promised, “If I’m president, we’re simply not going to do it.”  So, nothing is new, nothing has changed. 

We all know that Social Security will be a crisis at some point, but politicians refuse to deal with the realities.  This week, I discuss the looming Social Security crisis, the reforms that could head it off but won’t happen and why this issue so volatile.

Social Security – Tax or Savings Account?

One of the great myths about Social Security is that you are paying into a type of saving/retirement system that earmarks and protects your payments just for your benefit.  The truth is that you and your employer are paying a TAX that is currently being used to fund the benefits of those who have already retired (more on this below).  Workers pay 6.2% of earned income (up to $87,900 currently) to Social Security, along with 1.45% for Medicare.  Employers match both of these amounts.  The self-employed pay both these amounts. 

The idea of a “pay as you go” retirement system was developed during the 1930s when many people retired penniless.  Yet in the depths of the Depression, government bureaucrats knew that such a new, career-spanning tax would be very hard to sell.  So rather than depicting Social Security as a tax, it was touted as a government sponsored pension plan where workers AND their employers shared the cost.  It was sold as a new type of savings account (not a massive new tax), with employers footing half the tab, and it was received very well by the public.

From the beginning, the mindset of most Americans has been that the government can’t modify or change Social Security if it means any reduction in benefits, because they believe that the money they pay in will actually be used to fund their own benefits.  They believe it’s “their money” that is safely locked away for their retirement.  So why should any future benefits be reduced?

On the other hand, if the government wants to expand the benefits of Social Security (such as spousal benefits added in 1939 or cost of living increases added in 1950), that’s OK.  The public is more than happy to receive more benefits for the same money they pay in; they just don’t want less.  This is why enhancements to Social Security benefits have always been a good source of votes for politicians, especially among the elderly.

A Small Payroll Tax Increase Is Not The Solution

Shortly after Greenspan’s latest testimony in Congress, articles started being written regarding his statements.  Some of these articles agreed with Mr. Greenspan, but many others took issue with his bleak outlook.  One of the latest articles that disagreed with Greenspan is included as the first link in SPECIAL ARTICLES below.  This article argues that, with only a minor increase in the payroll tax, the Social Security system will be fully funded and solvent for decades to come.  Specifically, the article concludes that if we raise Social Security payroll taxes by only 1.92%, from 6.2% to 8.12%, all future problems will be averted.  

The problem is that this extra 1.92% would also be placed into the Social Security Trust Fund.  As we all know, the government has been borrowing from the Trust Fund surplus to pay for federal expenditures for years.  As a result, the cash in the Trust Fund has steadily been replaced by IOUs (government bonds), and is therefore just another unfunded government liability.

The bottom line is that at some point in the future, the government will exhaust the Social Security surplus and will have to redeem this mountain of unfunded bonds in order to pay benefits.  When this happens, the government will have no choice but to issue new revenue bonds to generate this cash, and this will serve to explode the federal deficits. 

Greenspan understands this.  In his February 25, 2004 testimony before the House Budget Committee, Mr. Greenspan said:

“The budget scenarios considered by the CBO in its December assessment of the long-term budget outlook offer a vivid--and sobering--illustration of the challenges we face as we prepare for the retirement of the baby-boom generation. These scenarios suggest that, under a range of reasonably plausible assumptions about spending and taxes, we could be in a situation in the decades ahead in which rapid increases in the unified budget deficit set in motion a dynamic in which large deficits result in ever-growing interest payments that augment deficits in future years. The resulting rise in the federal debt could drain funds away from private capital formation and thus over time slow the growth of living standards.” 

Clearly, Greenspan was not trying to direct his comments toward the Social Security Trust Fund itself, but rather to the fact that the Trust Fund is increasingly becoming nothing but smoke and mirrors (IOUs) and will cause potentially massive federal budget deficits in the future.  Surplus money in Social Security is being systematically drained away by the Treasury to pay for ongoing federal expenditures, and not safely stored in a so-called “lock box.”  Interest on this money has also been paid in the form of more IOUs.  No matter what you might hear, the well is going to run dry.

Timing The Crisis

Various forecasts suggest that the Social Security Trust Fund assets (accumulated surpluses plus interest) should peak at apprx. $2.3 trillion around the year 2017, again increasingly consisting of government bonds.  Currently, payments into the Social Security system exceed benefits paid out and should continue to do so for several more years.  However, the annual Social Security surpluses are projected to disappear between 2016 and 2018, meaning that benefits paid out will equal or exceed tax revenues going in.

Soon after that occurs, the Trustees will have to start liquidating the bonds to pay benefits, and this is when it will get very interesting!  When they do this, the government is going to have to come up with the money somewhere to redeem those trillions of dollars worth of bonds.  Of course, they won’t have to redeem all of them at one time - just enough each year to make up the difference between Social Security taxes collected and benefits paid out.  But the numbers add up fast!

As the baby boomers continue to retire, the annual Social Security shortfall will become huge.  Most of the academic studies agree that the projected Trust Fund balance of $2.3 trillion (including the bonds) will be exhausted by around 2042.  Yet all of these studies are based on some very optimistic assumptions, in my opinion.  These assumptions include, among others, a very strong economy, no major recessions or depressions, reasonably stable financial markets (including the dollar), no major wars, etc., etc. 

It is for this reason that I have long believed the Social Security crisis will hit well before 2042.  When the crisis is more likely to arise is a subject of great debate, but due to space limitations, we will have to revisit it at another time.

It’s The Deficit, Stupid!

If we stick with the mainstream projections, the government will have to start liquidating the bonds in the Social Security Trust Fund in 2016-2018 as noted above and in increasing numbers in each year thereafter.  Since these bonds are simply IOUs, the government will have to issue new debt to get the cash to pay benefits to retirees.  The new debt will likely be in the form of long-term Treasury bonds.

We can argue about how attractive (or not) long-term US Treasury bonds will be in 2016 and beyond.  Most academics and statisticians assume that it will be as easy to sell hundreds of billions in 30-year T-bonds in 2016 as it is today.  Of course, many of us could argue to the contrary, but for the sake of discussion….

The point is, federal deficits are going to EXPLODE in the future.  The numbers are huge.  And it doesn’t start in 2042 as some studies seem to assume.  The deficits related to Social Security start to rise in 2016-2018 (or I would argue even earlier).  We are talking about hundreds of billions of dollars per year, on top of whatever the federal budget deficit is for non-Social Security expenditures…  And this doesn’t include Medicare which will arguably be in worse shape than Social Security by that time.

By nature, I am not a gloom-and-doomer.  However, these numbers are very real, and I believe that the Social Security crisis will arrive well before the mainstream projections.  Whenever it happens, we will have to radically adjust our investment strategies – either to a wildly inflationary scenario or a debt deflation scenario – or maybe both.  This, too, is another (long) discussion for another time.

Alan’s Fix-It Shop

In his testimony before Congress, Greenspan offered up two proposals to help bring the Social Security system in line and possibly avoid future deficits spiraling out of control.  One of his proposals was to change the way in which cost of living increases (COLAs) are calculated.

In the original Social Security Act, benefits did not increase with inflation.  They were set (fixed) at retirement, just like most private pension benefits today.  However, in 1950, this all changed with the first adjustment for cost of living increases.  From 1950 to 1972, Social Security benefit increases were granted only by special acts of Congress, which made them political footballs. 

In 1972, a law was passed that made COLAs automatic, and based them on the Consumer Price Index (CPI).  This sounds great, except that there are a lot of different consumer price indices out there.  Various indices include and exclude different sectors of the economy, so getting the right index is very important.

The index chosen to base benefit increases upon is the Consumer Price Index for Urban Wage Earners and Clerical Workers (“CPI-W”).  This index assumes that consumers continue to buy the same basket of goods, no matter how inflation has affected the prices.  In 2002, the Labor Department started publishing a new CPI number, called the “Chained CPI.”   This new index takes into account that consumers will substitute goods when prices change.

Greenspan’s testimony indicated that the chained CPI would be superior to the old CPI-W that has been used, as it more accurately reflects consumer behavior.  Since it is usually lower than the CPI-W, it would also have the effect of reducing future COLAs, and thus the funding required for them.   So, opposition to this change will be enormous!

Increasing The Retirement Age (Again)

The other proposal floated by Greenspan was to increase the retirement age to reflect the longer life expectancies now evident due to better medical care and healthier lifestyles.  According to the National Center for Health Statistics (NCHS), the average life expectancy in 1935 when the Social Security Act was signed into law was 62 years of age.  This looks odd, since the initial retirement age for Social Security was set at age 65. 

The life expectancy for someone who had reached age 65 was approximately 13 years in the mid- 1930’s, while a 65-year old can expect to live over 18 more years today, based on 2001 data from the NCHS.  Thus, it would make sense that the Social Security retirement age would increase along with the increase in life expectancy.  In the early 1980s the retirement age was increased to age 67 for younger workers, but Greenspan said the retirement age needs to be “indexed” to life expectancy in order to keep the ratio of retirement years to working years consistent over time.

As I discussed earlier, Greenspan’s comments created a torrent of criticism from many sources, especially those with vested interests in the gray lobby.   However, if we are ever to fix the Social Security problems and avoid a crisis, some tough and politically incorrect steps have to be taken.


As noted at the beginning, there are four primary ways to avoid a crisis related to Social Security: 1) increase Social Security taxes; 2) reduce benefits for retirees; 3) raise the Social Security retirement age; and 4) use a different inflation index to calculate annual cost-of-living adjustments.  If some or all of these changes are not implemented, there is no question that we will face a serious Social Security related crisis in the not too distant future.

Politicians and gray lobbying groups get in high gear whenever changes to Social Security benefits are discussed.  The reason for this is that the system has been sold as a way to put back money for your retirement, a savings account if you will.  However, the reality is that you and I have paid a tax that was originally designed to be a pay-as-you-go system.  While your benefits may be based on your earnings, there is no bank account in your name that holds the money you have contributed.  The government has spent it and replaced it with paper IOUs.

Most academics seem to believe that the crisis, if there is one, will not hit until around 2042.  Yet as I have explained above, major problems could well start to occur whenever the government has to start converting those bonds to cash, and the budget deficits start to explode.  That could be in 2016-2018 or, I would argue, even sooner. 

Again, all these scenarios are based on economic assumptions that are far too optimistic in my opinion.  I may devote an upcoming issue of F&T E-Letter to a discussion of just how absurd most of these assumptions actually are, especially in the years after 2010.

At the end of the day, the question is: Will any Congress or any president actually tackle these delicate and hotly-charged issues?   It doesn’t look that way!  Because Americans feel vested in their Social Security benefits, it is likely that the hard choices will not be made until it is too late to avoid some major fiscal problems.

The future of Social Security also has important implications for the major investment markets.  That is another discussion we will have in upcoming issues.  Stay tuned.

All the best,

Gary D. Halbert



A brighter, but flawed, outlook for Social Security.

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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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