The Social Security funding process, as illustrated by Fool contributor Chuck Saletta: 1) You and your employer pay Social Security taxes. 2) Social Security pays benefits out of the taxes received. 3) The surplus Social Security tax receipts are loaned to the U.S. Treasury. (4) The U.S. Treasury gives the Social Security Administration bonds in return for that loan. 5) The U.S. Treasury pays the SSA interest on those bonds.
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Millions of Americans rely on Social Security, but the program has been in dire financial straits for years. Given the threat of long-term shortfalls, some believe the trust fund that holds Social Security's reserve assets should be allowed to invest in assets with higher potential returns than the government bonds it currently holds.
There has been much heated debate on this subject, so we asked two Motley Fool contributors to share their views both for and against allowing the Social Security Trust Fund to broaden its investment authorization. Let us know which view you agree with in the comments below.
Yes, the Social Security Trust Fund should change its investments to a safe and diversified portfolio outside of Treasury bonds, as this would reduce retirees absolute reliance on the governments ability to pay its debts. Allow me to explain.
Every year, the FICA tax you're charged goes toward paying Social Security and Medicare, and any excess goes to the Social Security and Medicare trust funds. You can think of this process as millions of Americans paying insurance premiums, while the funds collected are used to pay benefits now, and any excess is set aside for future benefit payments.
Like every insurance company, instead of sitting on the cash it brings in, the Social Security Trust Fund invests that money. By regulation, insurance companies must invest in a safe, diversified portfolio of investments so that even if the insurance company goes bankrupt, the people who bought insurance can still collect on it.
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However, the Social Security Trust Fund is only allowed one investment: special U.S. Treasury bonds. The Social Security Trust fund lends out its built-up funds to the government, which spends the money and gives bonds in return.
If the government is ever unable to meet its obligations -- that is, if it defaults on its debt -- there's no protection for the millions of Americans who rely on the Social Security Trust fund. This isnt unthinkable. In 2013, during the debt-ceiling crisis, the country came within a few weeks of defaulting, which Warren Buffett likened to a nuclear bomb.
If the Social Security Trust Fund had a portfolio of investments outside of U.S. government bonds, the U.S. could default on its debt, and the Social Security Trust Fund would still have $2.7 trillion in investments stashed away to pay out benefits, giving those who count on Social Security the financial security they deserve.
The second reason the Social Security Trust Fund should change its investments is that it would raise the return on the Social Security Trust fund's investments, allowing the Social Security Administration to continue paying full benefits without making dramatic changes to its level of taxation or its eligibility requirements.
The Social Security Trust Fund earns a meager return on its investments. Currently, the Trust Fund is investing new money at a 1.875% interest rate. Overall, the Trust Fund earned a 3.4% return on its investments in 2014, because, with interest rates at all-time lows, older bonds return more than current investments.
The Trust Fund could easily get a higher return in a diversified portfolio of stocks, corporate bonds, and other investments. A report by the Center for Retirement Research at Boston College estimated that investing 40% of the Trust Fund's $2.7 trillion in assets in stocks by 2020 would increase the fund's returns by 3.5% annually. That would reduce the Trust Fund's shortfall by 35%, enabling the Trust Fund to last many more years beyond 2033, when the fund is currently projected to run out of money.
While shifting some of the Social Security Trust Funds $2.7 trillion portfolio into equities would not be easy, numerous other countries, such as Japan and Norway, are investing comparable sums in worldwide stock markets and seeing much higher returns than the Social Security Trust Fund. Congress and the Trustees of the Social Security Trust Funds should take note.
Social Security has been at financial risk for years, and given the low returns on the government bonds that its trust fund is required to purchase, many Americans are naturally wondering whether the fund could do better by investing in stocks. Over the long run, simple index funds have dramatically exceeded the return on government bonds.
However, there are numerous problems with having the government invest directly in stocks. First, there are huge political risks involved in choosing certain companies over others -- remember the criticism the government received when it took equity positions in automakers and banks during the financial crisis. Even a broad-based index-like investment strategy would benefit some companies at the expense of others, and the huge increase in demand for shares would artificially lift the market and likely depress future returns not only for the government but for ordinary investors as well. Moreover, future downturns in the market could create short-term funding issues for Social Security, and huge potential swings in trust fund balances would raise worries about how to deal with shortfalls that may ultimately be short-term in nature.
Rather than having Social Security own stocks directly, the better solution for those who prefer stock investments is to have taxes fund private accounts for workers. As initially proposed years ago, private accounts would involve giving individual workers direct control of retirement money, which they could use to invest. Different proposals offer either select menus of funds and other simple investments or broader arrays of permissible investments in vehicles representing standard brokerage accounts. If any resulting stock exposure were kept separate from the Social Security system, beneficiaries could have the benefit of higher returns while still having a guarantee of at least some income regardless of market conditions. Private accounts get plenty of criticism as well, but conceptually, they're preferable to having the government directly investing in stocks.
The article Should the Social Security Trust Fund Change Its Investments? originally appeared on Fool.com.
Dan Caplinger has no position in any stocks mentioned. Dan Dzombak has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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