Guaranteed Retirement Income

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An ad by the AARP caught my ear during the Bud Billiken Parade broadcast by WGN on August 13. The ad’s part of a big AARP campaign focusing on Social Security. The AARP is against Social Security becoming a risky retirement plan. Their argument is that Social Security is "guaranteed retirement income" and should stay that way.

Forget the contradiction that they are calling Social Security guaranteed while arguing that Uncle Sam, who can change it at any time, shouldn’t. Let’s assume, for the sake of argument, that it is guaranteed. Let’s say that a subgroup (enrolled retirees) of the overall population is 100% assured of getting a level of real income in the future no matter what happens in the economy. Then it follows as the night follows the day that the rest of the population bears a greater uncertainty or risk in their income! This is basic finance.

The future is uncertain, so if income fluctuates, and one group always gets a fixed amount, the other group must get an amount that varies more. This is one factor that makes a bond and a stock differ. AARP wants Social Security to be a risk-free bond, but that means the non-retirees face the greater risk of a "stock." This point has nothing to do with transferring out-of-pocket wealth to the retirees from the non-retirees or any of the other ill-effects of the program. It focuses solely on the costs incurred by the non-retirees in guaranteeing an income to the retirees.

If you do not believe this, consider. Different income levels can occur in the future. The simplest possible case is when there are just two possible future states-of-the-world, a good outcome and a bad outcome. It’s like flipping a coin and seeing whether a good or a bad economy occurs. There are some numbers here, friends, but no more than simple arithmetic is required.

Suppose there is no Social Security program at all. Suppose the good state has total income of $1,000 and the bad state has total income of $500, and suppose there is a 50-50 chance of either state.

Good outcome = $1,000 total income

Bad outcome = $500 total income

Without Social Security, the average total income is $750.

Let the retired population be 20% of the total population, so they average $150 in income (0.2 x $750), sometimes getting $200 and sometimes getting $100.

Everyone else averages $600 (0.8 x $750), where they get $800 and $400 in the two states.

Before Social Security:

Good outcome: $200 to retirees and $800 to non-retirees

Bad outcome: $100 to retirees and $400 to non-retirees

Now a Social Security program is put in place. Let the fixed Social Security income be $150, which is the average of what the retirees would have earned prior to the program. This is siphoned off to the retirees, no matter what happens.

In the good state and bad state, that leaves $850 and $350 for everyone else. Their average is still $600. However, their income is now more variable or more risky. In the good state, they get $50 more or $850, but in the bad state, they get $50 less or $350.

After Social Security:

Good outcome: $150 to retirees and $850 to non-retirees

Bad outcome: $150 to retirees and $350 to non-retirees

The income level of the retirees has less variability after the program, but the income level of the non-retirees is more variable. This makes the retirees better off than before and the non-retirees worse off. Why? Because, generally speaking, most human beings are averse to risk. They pay less for variable income streams than for steady income streams, both of which produce the same average level of income. This is why stocks on average produce higher returns than bonds. It is why safer bonds provide lower yields than risky bonds. It is why people buy insurance against events that could make their wealth drop suddenly.

Even if the retirees keep working and earn no more on average than what they earned before, the guarantee is worth something to them. The rest of the population loses by providing that guarantee. The rest of the population is paying for an insurance policy for retirees.

Systemic risk cannot be made to disappear by guarantees made by the government. It can be shifted around, repackaged, sliced and diced, passed from one group to another, but it does not go away.

Security in the form of guarantees brought to you compliments of Uncle Sam is (at best) a zero-sum game in which the winners take from the losers. Of course, it’s a negative sum game when evaluated in full, when all the negative incentive and other effects are factored in.

Federal Deposit Insurance for bank accounts guarantees the depositor’s deposit no matter what state of the world (or economy) occurs. If bad times occur and banks fail, the depositors will be paid just like retirees. They may be paid by taxpayers at large. They may be paid via money printed by the Federal Reserve which will entail taxes through inflation. They may be paid by forcing sound banks to absorb unsound banks, another form of taxation. The failure of the Federal Savings and Loan Insurance Corporation cost taxpayers around $200 billion.

In fairness, banks do pay premiums to the FDIC for the insurance, and academics dispute whether the premiums are actually too big, in which banks are being taxed, or too small, in which case banks are being subsidized. However, should any really catastrophic event occur, the debate will be over. It will then be clear that taxpayers lose and bank depositors gain.

The Pension Benefit Guaranty Corporation (PBGC) is another federal guarantee entity. This one guarantees some pensions of companies, who have been paying in premiums. If the companies fail, the pensioners still receive their pensions. The insurance fund of this government corporation has been exhausted due to a number of company failures. The fund has a deficit of about $23 billion and unknown liabilities. They are unknown because no one knows what claims might occur in the future when companies fail. We do know that unfunded pension liabilities of covered companies are somewhere around $250—$300 billion, possibly as high as $450 billion since companies often use over-optimistic earnings projections on their pension assets.

Then there are the direct loan and loan guarantee programs of the federal government, those of the Small Business Administration, the Farmers Home Administration, the Economic Development Administration, and the Government National Mortgage Association. Providing a complete list might delay publication of this article for an indefinite period.

When the government acts like an insurance company, the taxpayers pay for the policies.

The government has extended a huge amount of loan and income guarantees. In any really bad depression, there would be financial difficulties in meeting these obligations. They would require financing from somewhere if they were not to be defaulted on. Congress probably would not impose drastic new taxes on the taxpayer, especially in bad times. But it might, if that’s what it took to maintain the credit of the U.S. government. It has done so before. Congress could borrow the money. The Federal Reserve would monetize the debt and create inflation. This is what it’s there for, to create inflation. This provides a variety of default in real terms, but not in nominal terms. One wonders how many more times the Fed can bail out the U.S. government before the system collapses.

Loan and income guarantees are a big iceberg from which the Titanic’s Captains wish to avert their gaze. While doing so, they prefer to party hard with new guarantees of prescription drug benefits, promises of freedom for all those under tyrannies, and wars to destroy phantom weapons of mass destruction.

In a way, many spending programs are analogous to Social Security or pension fund guarantees. They impose long-term cash payouts. Unless the State is somehow seriously restricted, one of its major diversions is to create spending obligations. This naturally imposes greater income variability on taxpayers. This is a hidden source of loss to the taxpayers. If they should fall out of work, why then we just create unemployment insurance! This shifts risk to yet another group, those who are still working. With any really serious shock to this system, who will be left to pay the tab? We will. We’ll still be here, but we will have to sell off our assets to do so. Balance sheets balance. If the State creates liabilities, it will tap our assets if it has to in order to meet those obligations, or else it will go belly up. That’s not such a bad idea, is it?

Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.

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