I outline below an argument purporting to demonstrate that the
proposed "personal accounts" for social security will actually hurt
the finances of the social security sysstem.  Is there a fundamental
flaw in my analysis of the impact of "personal accounts" on the
financial health of the social security reirement program?

BACKGROUND: In order to provide lower-income Americans with enough
money in their retirement to avoid severe hardship, the payout formula
on social security favors low-income persons.  For someone retiring in
2003, Social Security calculated Average Indexed Monthly Earnings
(AIME). Earnings in earlier years are indexed based on changes in
average wages so that all earnings are expressed in 2003 dollars.  On
the first $606 of earnings, Social Security paid 90%, i.e. monthly
earnings of $606 resulted in social seecurity monthly payments of
$545.40. For the next $3,407, Social Security paid 32%, or $975.04. 
For the final $3,653, Social Security paid 15%, or $547.95.  This
formula is very helpful to poor persons and, if my analysis is
correct, this formula provides the Social Security Fund with profits
on taxes paid by individual on their earnings in the "15%" category.

The administration is proposing that workers bve given the option of
diverting a part of their social security payments to a personal
account.  I am looking at the impact on Social Security of this
proposal for persons earning enough money so that a part of their
earnings would result in 15% payments.  For ease of computation, I'm
using a model where a person earns the maximum amount subject to the
15% payment.  The analysis should be valid for someone who makes any
payments into social security in the 15% category.

Looking to the future, I project the impact of persons who earn the
maximum amount subject to Social Security and who are permitted to
divert all their "15%' money to a personal account.  It is assume that
Social Security would not provide any "15%" benefits to these persons
since these persons put their funds in a "personal account" which
presumably will increase in value.  the analysis is in 2003 dollars.

Over a 35 year period, the $3,653 annual earnings in the 15% category
would total $1,534,260.  Social Security taxes for the retirement fund
(Old-Age & Survivors Insurance--OASI) of 10.6% would generate
$162,631.56 for the retirement fund.

Total pay-outs would depend on the average life expectancy of persons
in the 15% category reaching the age of 65. It is assumed that the
average life expectancy of these people reaching 65 will be 20 years.
(Currently, the life expectancy of all persons reaching 65 is roughly
18 years.)  With a monthly payout by Social Security of $547.95 for
the "15%" money, there would be payouts of $6,575 per year, or
$131,508 for 20 years.

Thus, using the calculations outlined above, Social Security would
receive $162,632 from Social Security retirement taxes on the 15%
money per person and pay out $131,508--resulting in a Social Security
"profit" of $31,124 per person.

Two factors not discussed above would have to be considered in
determining whether Social Security makes a "profit" on individual
payments falling into the "15%" category.  Certain spouses of persons
getting social security also receive social security just because they
are married to a social security recipient.  Thus, the analysis above
does not take into account all the payouts required under current
Social Security rules.  However, the above analysis assumes that all
persons make payments into social security over a 35 year period and
will draw benefits for an average of 20 years.  Actually, a number of
persons without dependents make payments over a long period of time
but die before they draw any benefits themselves.  All of their
payments contribute to the Social Security Fund's profits.  This group
of persons provides an important source of funds to social security. 
(Upper income persons also pay taxes on part of their social security
receipts and these payments go to the Social Security Fund.  The above
analysis does not include such sources of profits for Social Security.
 On balance, it is assumed that these various factors basically offset
each other and that they do not affect the validity of the analysis.

If this analysis is correct, and if funds are diverted to private
accounts which otherwise would have gone to the Social Security Fund
as "15%" funds, then the creation of personal accounts will hurt the
finances of Social Security. Instead of the Social Security Fund
running out of assets in,say, 2042, the Social Security Fund will run
out of funds before then.  Diverting money to personal accounts may or
may not be good public policy, but this diversion will hurt the Social
Security Fund--the diversion of funds to personal accounts will not
help to save the Social Security Fund.

Comments on this analysis are welcome.  However, a successful answer
would have to provide a reasoned and valid argument as to why the
analysis is incorrect.

The fundamental flaw in your logic is that Social Security (SS) is no
longer an individual account within the government.  For decades this
pool of money has been mixed with the general government funds and
this will continue indefinately.

You are right that creating private accounts will in the short run
bring in less SS revenues but keep payouts about the same.  But this
will put a burden on the government as a whole, not on the SS system
itself.

What do you think would happen if SS suddenly took in less money than
it brought in?  The government would simply fund the difference (much
like the government currently just eats up the difference due to the
extra money that SS brings in).  Sure the government will then go into
more debt, but that's a whole different issue...

So what should be done?  
I think that private accounts are a good idea.  15% is more than
should be started with... perhaps 5% to start and then increasing 5%
every couple years if things go relatively smoothly.  Introducing
capatalism and ownership into a socialistic policy will help matters
alot in the long run.
Also, SS benefits are currently increasing faster than real inflation.
 This is caused by a couple things, but regardless of the cause it
needs to be stopped.  I would in fact increase SS by 1% less than
inflation every year.  This would slowly ease the burden on the
government without putting a large burden on anyone.
ie  If I'm currently receiving $1,000 per month and inflation for 2004
was 3% then in 2005 I'd receive $1,020 (instead of $1,030 if the
increase were to match inflation).

A MAJOR problem with private accounts is that people who know how to
invest their own money already save and invest.

The proposition that the average minimum wage worker will know how to
invest their savings wisely is just plain silly.

Another problem with private accounts is the simple fact that recent
stock market gains have averaged well above normal for the past 100+
years. Since such things almost invariably return to the mean, the
prospect for average returns over the next thirty years is that they
will be well below normal, which means a few percent at best.

Those are good points Silicon.

I mentioned in another thread about SS that the government should
provide investment options for that optional money to go into. 
Currently the government runs a "thrift savings plan" for its
employees that seems very well managed.  The costs are very minimal
and the investment opportunities are quite respectable... the funds
are:
govt bond fund
corporate bond fund
S&P Index fund
Wilshire Index
International fund Index (i forgot which index this actually is)

If the government expanded this service to the private accounts then
there would be much interest to be gained by the american people (as
well as a bolster to investments which should in turn help businesses
to become more profitable).  Given these options, it's hard to imagine
anyone would make less money than they would in the current SS
program.

To address your second concern, past performance is not indicative of
future results.  Wherever the stock markets happen to be right now
does not indicate where they will be a year from now, 2 years, 10
years... if you are suggesting that the market is due a collapse
because it has experienced large gains in the past 3 years then you
are mistaken.  The 80s and 90s saw much more of a rise than the 00s
have so far yet the collapse was 18 years in the making.  I'll agree
that there is a potential bubble effect that can effect performance in
the short run, but in the long run (we are talking about retirement
accounts, right?) the market has and will continue (assuming the US
doesn't get nuked into oblivion or have another national catastrophe
of the like) to rise at a good rate likely over 10%.

Also note that about 50% of the money in the current thrift savings
plan is in the government bond fund.  Although this isn't the place I
would have my money, it shows that when people on average are
encouraged heavily to invest that they are on the safe side of
investing rather than the risky side.

Moosetail-ga:
"Is there a fundamental
flaw in my analysis of the impact of "personal accounts" on the
financial health of the social security reirement program?"

Yes-sort of.  The idea is that there shouldn't really be a program
with its own financial health that matters, only individual accounts
that individuals are responsible for.  If an individual does something
dumb and their account crashes, the proponents of private accounts
don't see that as "wrong" (not the same as "bad").  It is not a
financial argument, it is a political/philosophical argument.  You may
be correct, but at least half of the battle is not talking about the
same thing you are analyzing.


Siliconsamurai-ga:
"Another problem with private accounts is the simple fact that recent
stock market gains have averaged well above normal for the past 100+
years."

"Average" and "normal" are not fixed.  If stock market gains have been
above normal for 100+ years, maybe we have the wrong idea of what
normal is.  This is also a pointless argument because the SS
Administration has the same economy available to invest in as we do. 
If any particular investment is a dead end, it affects both options.

Carl, that last point is an interesting one.  I would like to think
that you misread Silicon's comment...  how I read it, he means that in
recent years the market has performed better than it has over the past
100 years (and I'm almost certain that is what he meant however the
wording doesn't make that completely clear).

But if my reading of Silicon's post is correct then he does put faith
in the stock market, since over 100 years it has average over 10%
annually.  Also an important point to mention is that it is extremely
rare to find a 10 year period when safe bonds outperformed the stock
market (although there are those rare cases) and everyone under 55
(the people Bush will allow to use the personal accounts) as more than
10 years before they can start cashing in their accounts.

jack_of_few_trades-ga:

Reading it again, I see what you mean.  It could easily mean that (and
most likely does).  But while it sounds less ridiculous to read it
that way, the failure of that argument to mean anything remains.  As
you note in your second paragraph the stock market has proven to be a
great long term investment.

What also still remains is the fact that the government does not have
magic investments.  Unless they invest retirement money in the
economy, just like individuals would, inflation would eat it away.

Here are some numbers Carl:

Let's assume the stock market (an index fund that the govt uses)
averages only 10% (which is below average) after the minor expenses
involved.  Inflation over the last couple decades has been around
2.5%, but let's assume it's at 3% over the next couple decades.
So we're assuming below average returns and above average inflation. 
This should all help your argument and hurt mine.

Now, a person invests $1,000 for 30 years.  If inflation eats all of
the profits up as you suggest then the person should be left with
$30,000 in real money.  But doing the math...
$1,000 for 30 years turns into $200,000 
http://www.tcalc.com/tvwww.dll?Save
In 30 years, inflation will make every $1 worth $0.40
This means that the $200,000 will be worth $80,000.  That is almost
triple what it would be if inflation ate up all the returns as you
suggested.

Now if you do the math for 11% return and 2.5% inflation (more likely,
however not guaranteed of course), you will see that you have $250,000
and it will be worth $120,000 in todays dollars.  That is 4 times your
investment.

Right now social security's real rate of return is below 2%. 
http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-34.html#subhead1

Compare this to the approximate 8% real rate of return you are likely
to achieve in the stock market and it's really nothing at all.
$1000 per year for 30 years at 2% = $45,000 (very little compared to
the $80,000 or $120,000 that is very likely in the stock market).

jack_of_few_trades-ga,

Let's examine my statement again:
"Unless they invest retirement money in the
economy, just like individuals would, inflation would eat it away."

This is an either/or statement.  I did not say inflation would eat the
profits (even though it does, that just wasn't the issue).  I said
that without profits inflation would eat the principle.

Yes, I meant that, by all historical measures the stock market seems
to be overvalued recently (a decade or so) vs such things as earnings.

Although this might continue indefinately, most things don't go up
forever and it is unlikely that we will see stock indexes (one major
way proposed to invest these funds) continue to rise at an average
rate over the next decade as they have over the past few decades.

this is what I posted in one of my blogs a few days ago.

From what I have seen of it, the Bush proposal for reforming Social
Security goes as follows:

At a cost of unknown billions of taxpayer dollars people under 55 will
be allowed to put some of their SS tax money into private accounts and
invest it.

When they retire the government will take that money and give some of
it back in a slow trickle.

Even the Administration admits that this will do absolutely nothing to
ease the so called SS crisis.

Now, to me, this seems to make as much sense as promoting the
collecting of Elvis memorial plates as sound retirement planning.

Silicon,

You are right that in the short run this will cost unknown billions of
dollars.  Where you are wrong is your thought that there will be no
benefit.

When the people who take up this option to invest their own money
start to retire, they will receive decreased benefits (because they
will have money in their personal accounts to make up more than the
difference).
Bush proposed that these people receive normal benefits minus what
they chose to invest (plus a low interest and inflation).  That will
be a huge amount of money that the government will save when paying
for their retirement.

It's obvious to everyone that social security cannot go on forever as
it is going now.  Estimates vary over about a decade of when the
system will fail, but it's very clear that IT WILL FAIL.  Bush is
providing an idea that will cost money today but will save that same
money plus interest and inflation in the future, and will provide
younger retirement planners an option in their retirement funding
(moving from socialism to capitalism).

I have not seen any other options seriously proposed, but I would like
to see more so we can compare the plans.  But the fact still stands
that social security as it is WILL FAIL.  What would you suggest to
save it or phase it out Silicon?