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Yes, Social Security needs fixing, but ...

You know those Social Security statements that you get in the mail every year? The ones that arrive a couple months before your birthday? Read it and weep, because unless you're 55 or older today, chances are your benefits will not look quite as good as what's promised on that statement.

They are calculated under the traditional Social Security system.

That system is getting ripped apart by rhetoric emanating from the White House and Capitol Hill. In fact, you can hear it all across the country now. Earlier this month President Bush kicked off a road show, dubbed "60 stops in 60 days," to garner widespread support for his plan to "strengthen Social Security for future generations." Through May 1, top administration officials will follow the president's lead by spreading the message to young and old alike at town hall meetings across America.

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Their message: There is a problem with Social Security. How do we fix it?

It's true that the system is old and needs some fixin'. Social Security is a pay-as-you-go system where current workers are providing for the incomes of current retirees. This system has worked for decades because the ratio of workers to retirees has been high. But now, as the baby-booming masses face retirement, the numbers will get dicey. In 1950, when many of us were still glints in our parents' eyes, there were 16 workers for every retiree. Today, we're down to 3.3 workers. By 2040, the ratio will be two to one, according to projections.

And much sooner than that -- by 2018 -- the system will become insolvent as revenues (meaning, the Social Security tax that is deducted from your paycheck) will be insufficient to cover expenses (meaning retirees' checks). Logical ways to fix it are to increase taxes, delay the retirement age or decrease the benefits. These strategies have already been implemented in the 1980s.

President Bush deserves credit for putting the problems of Social Security in the spotlight and making it a priority for his second term. But his plan to allow Americans to divert a portion of their Social Security tax into personal accounts subjects this money to the vicissitudes of the financial markets, and Americans already face enough risk in their retirement accounts.

Here's how his plan works (subject to revision, of course):

  • Workers could divert 4 percent of their payroll earnings into private accounts, subject to a limit of $1,000 in the first year. This cap would gradually increase in annual increments of $100.
  • The money could be invested in a handful of funds, including those focusing on large-cap stocks, small-cap stocks, international stocks, corporate bonds and Treasury bonds. Life-cycle funds, which offer a mix of stocks and bonds targeted to investors of particular ages, would also be available.
  • Participants could not access money for any reason prior to retirement. Once they reach retirement age, they would get annuities through the federal government that assures them of lifetime income streams.
  • Any excess money earned above a particular level could be reinvested, bequeathed to heirs or withdrawn in lump sums to be spent on as-yet-undefined "pressing financial needs." However, retirees wouldn't be able to withdraw lump sums from their private accounts if doing so would place them below the poverty level.
  • The program would begin in 2009 for those born between 1950 and 1965; it would phase in the younger populations over the next two years. Those born before 1950 would continue to receive benefits under the traditional system.
  • The program would be voluntary. You could elect to receive benefits under the traditional system. If you do choose a personal account, your benefits under the old system would be reduced by an amount "equal in present value to the money placed in the private accounts up front," in the words of a senior administration official.
  • Those who opt out of the personal accounts would not likely get the benefits described in the statement you receive in the mail each year. Unless there's a large tax increase, you can expect to get less, according to the official.
  • This new personal-account program would do nothing to alleviate the insolvency issue facing the current Social Security system, and transition costs to make it happen would be $754 billion through 2015, according to government estimates.

So let's do a calculation to see how a private account might grow for the median-age baby boomer (born in 1955) who opts to open a private account.

The calculation involves a lot of guesswork. For example, you have to guess the type of return you could expect from the various asset classes that you could invest in. Actuaries -- who are paid big bucks to read the tea leaves of probabilities -- predict annual returns of 6.5 percent for stocks; 3.5 percent for corporate bonds and 3 percent for government bonds. All three are post-inflation returns, with inflation estimated at 3 percent annually. Critics say these projected returns are unrealistically high.

Nevertheless, we'll go with those returns as a basis for our hypothetical portfolio, which would be composed of 60 percent stocks, 24 percent corporate bonds and 16 percent government bonds. Using the above returns, the portfolio's overall return would be 4.92 percent (after subtracting a 0.30 percent management fee to run the funds).

Guess how much the baby boomer who was born in 1955 ends up with by the time he or she reaches age 67? A grand total of (drum roll, please) $28,349.

That's not a heck of a lot, though it would be supplemented by a traditional Social Security benefit, reduced by the amount of money diverted plus the amount it would have earned up to 3 percent above inflation. Confused? Me, too.

It involves taking a lot of risk for low expected returns, especially for boomers. Generation X and Y would fare better if market forces cooperated, thanks to the power of compounding.

But the administrative officials are right when they say there is a problem with Social Security. And since they're asking how to fix it, let's offer some solutions.

For years now, Social Security taxes have generated huge surpluses. Last year's amounted to $152 billion. This year's will be $10 billion higher than that. Unfortunately, instead of saving and investing this surplus, our government is using it to reduce the ever-widening budget deficit. In fact, this has been going on since the 1980s, an unintended consequence of fixin' the system back then.

We as Americans are expected to exercise restraint and put aside some money for our retirement. If we spend everything we make today, we'll have nothing left for our golden years. Why can't our government officials also be so disciplined? If they set aside the surplus instead of spending it, Social Security would not be in crisis mode, and bankruptcy would not be an issue.

Solution No. 1: Don't spend our future retirement money on the superfluous needs of special interest groups.

Currently, 6.2 percent of your wages goes to pay for Social Security; your employer matches that amount, so the government gets 12.4 percent. But that money is collected on salaries of up to $90,000. Individuals who make more than that pay no more toward Social Security.

Solution No. 2: Raise the $90,000 ceiling for Social Security taxation to $200,000 or even higher.

There are plenty of other solutions, too, such as reinstating the federal estate tax, which is scheduled to sunset in 2010, or undoing the income-tax rate cuts for those at the top end of the income scale. Such moves might not affect Social Security directly, but it would do much to reduce the deficit. Then the government could stop using Social Security surplus funds to try to stop the budget from hemorrhaging.

Roughly two-thirds of retired Americans rely on Social Security for half or more of their household incomes. For one-fifth, that check represents their only source of income. It's the one part of the retirement equation that Americans must be able to count on.

If you're not happy with the idea of personal accounts, let your senators and representatives in Congress know. They need to know how their constituents feel about the matter. We are already taking enough risk as we manage our retirement accounts. Tell your lawmakers to fix Social Security so that we can get the benefits that we've been promised year after year.

Longtime financial journalist Barbara Mlotek Whelehan earned a certificate of specialization in financial planning.

If you have a comment or suggestion, write to Boomer Bucks. If you have a particular financial problem that you would like addressed, please send your queries to Dr. Don, Tax Talk, the Real Estate Adviser or the Debt Adviser.


-- Posted: March 9, 2005




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