The best arguments for Social Security

By Fester:

William Saletan (via Andrew Sullivan) inadvertantly makes two very strong arguments for Social Security as a means of multiple risk spreading across the entire population and thus the entire risk pool:

As the latest Reuters report notes, over the last four decades, U.S. life expectancy has climbed from 70.8 to 77.8 years. By 2015, it's on track to hit 79.2 years. Meanwhile, unlike other industrialized democracies, the United States has replaced pensions with 401(k) plans. So your retirement-income pie can suddenly shrink—as, for example, it's doing right now—and, at the same time, the longevity you've gained from all this lovely industrialization requires you to carve that pie into more and more annual pieces.

He identifies two risks.  The easiest risk is the risk of outliving one's assets.  As a late twenty something, I have absolutely no clue how long I am going to live.  I am in pretty good health right now, and in good shape.  My family history is favorable, but I am also a clutz, so I could live for another week, or I could coceivably live for another century, especially as I enjoyed some revistroral for dinner tonight.   Even with the information advantage on my side compared to that of an annuity company, there is massive individual uncertainty on my projected lifespan. 

If everyone had to save individually, they would be forced to make the decision to insure against a long tail distribution (living until 95) or eating dog food if they made it to 85.    This can lead to an inefficienct distribution of capital and savings, especially in times of a liquidity trap.  Social Security takes the small risk of living to 100 or more and spreads the risk over the entire population.  This means that individual supplemental savings such as a 401(K) do not need to have as large and inefficient allocation of assets to insure against a low probability event.  People can pay much closer to actuarially fair prices to avoid the possibility of eating dog food in their old age instead of paying normal risk averse prices.  That extra capital can be used for either consumption or for more risky investments.

The more important argument that Salatan inadvertantly makes is the systemic risk argument.  People are bounded by their rationality.  No one can be in an expert in everything and the development of heuristics and schemas for non-expert problem solving also create blind spots.  So if individuals follow their expert approved or provided investment schemas and heuristics they'll still be blindsided by massively odd and unusual results such as a 40% drop in the stock market in the past year, or a massive bubble and popduring the Internet Boom years.  Timing here is critical, for an individual who got out and annuitized in 2007 is eating very well, while an individual who has to get out now is looking at eating dog food. 

We as a society want to encourage good decision making and when someone invests all of their money into a Nigerian 419 scam, we should not protect them. However when people are following the rules and decision systems that we as a society deem valuable and they get kicked in the nuts for that, that is a bad incentive system.  Base income in the form of Social Security system removes some of that short term systemic risk by spreading it across multiple years and allowing a good year or two to pay off a couple of bad years. 

The best arguments against Social Security are of the 'eating babies' type of arguments, where they are most valid when everything else has already collapsed and worrying about retirement policy is an absurd abstraction. 

Comments

[Zifnab]

Ok, two things to consider.

Firstly, if you're on the verge of retirement and you've still got 50% or more of your assets directly invested in the market, you are running your 401(k) incorrectly. The proper way to distribute your personal pension pie is high risk at a young age and increasingly lower risk as you get closer to retirement. So by the age of 60, you should be looking at the majority of your wealth invested in low-risk bonds and CDs rather than high volatility mutual funds or stock buys.

Now, many people don't know the various savings techniques that go into long term sustainable retirement, so its understandable that this is a flaw in the system. But the flaw is in the investors' knowledge, not the 401(k) system. Take a pension fund or even the entire SS system and turn it over to bad managers and you find yourself in the same boat as you do today. The question is whether individuals are better able to manage their assets at a micro-level than a general funds manager would be able to at a macro-level.

And this brings us to our second point. One of the reasons a large trust fund works, but smaller trust funds can also work stems from the returns on large blocks of wealth. Assuming you hit retirement at 65 and you've saved up a million dollars. Investing in safe, FDIC insured, reliable investment vehicles like CDs, bonds, or annuities can generate income in the 4-6% range. On a million dollars, that's $40 - 60k per year. While not lavish, for a middle income retirement guy or girl that's definitely livable. And you don't have to touch the principle for the rest of your life.

Pooling resources and letting the government manage everyone's money can create a system with the same effect. With 300 million citizens, the US can accrue large reserves from which to generate income. This income then gets paid out to the seniors in need. And the principle never gets touched.

This is - of course - assuming the funds are managed responsibly. Get a GOoPer like Bush in charge of the national pension plan, however, and suddenly you've got a clusterfuck waiting to happen. If Social Security starts falling apart due to poor management, I can't fight cuts to my already meager pension payouts. But I've got confidence in my own personal 401(k). If I fuck that up, I've got no one to blame but myself. But I'm still more confident in myself than in my government.

For that reason, I think the bi-lateral strategy is really the best approach. People need personal retirement accounts AND social security. Each serves as a safety net against the other. The current SS system needs reform and the 401(k) system could definitely use better and stricter guidelines. But they are together stronger than any one program individually.

[Andrew Biggs]

The Saletan article points out rising life spans, but Social Security doesn't have any particular advantage in dealing with those -- if people live on average 20 years past retirement rather than 10 years, then Social Security costs will double. That's pretty simple math.

Where Social Security does have an advantage is regarding uncertainty of lifetimes, which can happen when average life expectancies are either short or long. An annuity like Social Security benefits provides BIG advantages versus just drawing down a lump sum at 4% a year or whatever. The insurance protection against outliving your assets is very valuable.

That said, you can purchase insurance against outliving your assets at relatively low cost. At retirement age, purchase a deferred annuity that will begin payments only at (say) age 85. The annuity will be cheap, since many purchasers will die before collecting, but in the odd case you live extra long you're protected.

Social Security has some advantages over private markets in this regard, but also many disadvantages in other respects. So it's really a balance between Social Security and private savings.