Solving Social Security With Cheap Money

The budget challenge posed by the retirement of the baby boom behemoth has been acknowledged and expected for decades: With fewer workers supporting each retiree, the Social Security program would become insolvent, or become so expensive as to be unaffordable.

Late last week, the program's trustees furthered that argument, projecting that the retirement security trust fund will run out of cash in 2036 -- unless something changes about the way the program collects and spends revenues.

For almost as long as actuaries have been warning about the impending crunch, some observers (including, ahem, me) have expected the problem to be solved by paying off oldsters with cheap money. That is, a hefty round of inflation that would reduce the real growth of Social Security benefit, so retirees could feel like they were getting a lot of dollars, but the real budgetary hit would be reduced.

Indeed, many economists have cited the Federal Reserve's easy-money policies and recent increases in food and energy prices as proof that we are well on our way to another inflationary period.

The counter-argument has been made: Social Security already includes an automatic cost-of-living adjustment (COLA) based on the consumer price index. So, any increase in inflation would automatically get fed back into the program, right?

That is true, but not the whole story.

In the first place, inflation already erodes a bit of that Social Security benefit in two ways. The cost-of-living adjustment already lags the CPI data by at least three months, allowing some benefit depreciation to creep into the payments.

And the index used to adjust benefits -- the so-called CPI-W -- probably understates the kind of price increases elderly people face.

An experimental CPI that aims to measure the cost of living for consumers over the age of 62, called the CPI-E, has been rising faster than the CPI-W since its inception in the early 1980s. For the last 10 years, the CPI-W has grown at an average annual rate of 2.5%; the CPI-E has grown at 2.65%, probably because of rapidly rising healthcare costs that make up a larger percentage of retirees' expenses than those of younger workers.

Politically speaking, there are ways to tinker with the inflation adjustment that would help close program shortfalls while mostly flying below the radar. That could seduce politicians of both parties who want to address Social Security without openly riling retirees.

Policymakers could switch the index upon which the COLA is based to another experimental measure called the "Chained CPI." That measure, which adjusts for how spending patterns change when prices rise, shaves some of the inflation out of its price measurements. During the last 10 years, it has been rising at an annual rate of 2.2%.

Alternatively, policymakers could build a longer lag into the Social Security COLA by delaying the adjustment for three months every year, as they did in 1983 when they shifted the adjustment from October to January. Or, they could simply decide to subtract a percentage point from the annual COLA for all but the lowest earning recipients.

Put all of that together, and current and future retirees would do well to prepare for some cheaper dollars in their benefit checks in the future. Here's how:

-- Earn money on inflation. When prices rise over long periods, interest rates usually do too. Retirees who have significant savings can capitalize on that by buying money market mutual funds and short-term certificates of deposit that will capture rate hikes. They can also tuck some inflation-protected bonds into their tax-deferred accounts.

-- Hedge inflation. The housing market may or may not recover anytime soon, depending on where you live. But if you own your house outright, or are paying for it with a fixed-rate low-interest rate loan, you are somewhat protected from the cost of housing going up in the future. Other ways to protect the retirement kitty from U.S. inflation would include investing some of it in foreign-denominated stocks and bonds, keeping a small portion of your money invested in commodities, and making sure some of your retirement assets are invested for long-term growth (stocks) instead of short-term income (bonds.)

-- Solve the health-care dilemma separately. The real inflation problem for retirees is the interplay of these two factors: (1) As they age, people spend a higher percentage of their income on health care, and (2) healthcare costs have been rising more rapidly than consumer inflation. So come up with a plan for covering healthcare down the road. It can include a solid long-term care insurance policy with an inflation adjuster, a good Medigap policy and/or a bucket of savings. (Retiree health-care costs have been put at $230,000 per person by Fidelity Investments.)

-- Remember that your spending will adjust, too. Except for healthcare, retiree spending does trend down over the years. People in their 80s just don't have the same life styles as they did when they were in their 60s, so they may not need a dollar-for-dollar COLA. They don't travel as much, drive as much, buy as many clothes or even eat as much. So, if the COLA gets shaved a little bit, the monthly Social Security check could account for a higher percentage of everyday expenses in the future.