05 June 2012

Models and Assumptions

A much better alternative is for the household to “buy” an annuity from Social Security. They can make this “purchase” by using their savings to pay current expenses and delaying claiming to get a higher monthly benefit at an older age. The savings used is the “price” and the increase in monthly benefits is the annuity it “buys.”
For example, consider a retiree who could claim $12,000 a year at age 65 and $12,860 at age 66 – $860 more. If he delays claiming for a year and uses $12,860 from savings to pay the bills that year, $12,860 is the price of the extra $860 annuity income.[1] The annuity rate – the additional annuity income as a percent of the purchase price – would be 6.7 percent ($860/$12,860). Remember that Social Security benefits are indexed for inflation, so the retiree is buying a real annuity. Vanguard – a wonderful company – also sells real annuities but it pays much lower rates.

This is all a lot of wonderful math, but the validity of the analysis is predicated on the assumption that Social Security is a reliable source of income.  Currently, it is.  However, it’s long-term reliability is very much in doubt.

The reason for this is simple, and two-fold.  First, Social Security is primarily redistributive, in that it distributes current taxes instead of invested savings that were paid in by participants.  Second, and more perniciously, a good portion of Social Security’s investments consist of owning federal government debt.  As Social Security continues to run a deficit, it will have to sell the US bonds it currently holds.  There are a couple of things that can happen.  The government can raise taxes in order to buy back the bonds, the fed can print money to buy the bonds, private investors can forego investing in productive ventures, or consumer can forego consumption.  With the exception of inflation, all of the choices require taking at least a short-run hit in aggregate standard of living.  Inflation merely requires taking that hit in the long-run.  To put it more simply, Social Security’s continued success as an investment is contingent on screwing taxpayers over.  Needless to say, this may not make for the most reliable of investment programs.  Just ask Bernie Madoff.


  1. Heh. Funny that you mention Mr. Madoff, who went to jail for doing privately what SS does publicly (i.e., running a pyramid scheme).

    That's another reason why SS is conceptually faulty, in addition to what you wrote.

  2. @EW- It was intentional. The theory is that money earmarked for SS is invested and doled out later. The reality is that current taxes pay current obligations. I don't see how Madoff goes to jail for doing this while legislators walk free.