The Social Security Trust Fund, part I

One of the most confusing pieces of the Social Security issue is the so-called trust fund. It's confusing because there is an ongoing debate over whether it even exists.

President Bush weighed in on the no-trust-fund side a couple of times, the latest last week. Of course, this contradicts his State of the Union speech in 2001:

"To make sure the retirement savings of America's seniors are not diverted to any other program, my budget protects all $2.6 trillion of the Social Security surplus for Social Security, and for Social Security alone."

What a difference a couple of years makes. Here's what he said last month:

"Some in our country think that Social Security is a trust fund - in other words, there's a pile of money being accumulated. That's just simply not true. The money - payroll taxes going into the Social Security are spent. They're spent on benefits and they're spent on government programs. There is no trust."

So, if there is no Social Security trust fund, what happened to that $2.6 trillion? If a slick politician was to pull this kind of swindle in small town Nevada, there would be a lynch mob running after him with a rope.

As with most political tug-o-wars, the truth about the trust fund lies somewhere in the mud pit between the two opposing forces.

It turns out there is a trust fund. One can read about it in the Social Security Trustees report. It consists of special-issue Treasury bonds, stored in a vault in West Virginia.

But what the no-trust-fund proponents say is these bonds are just paper, a promise by the government to pay, and therefore meaningless.

True, these are just paper. Just like the trillions of dollars of other Treasury notes sitting in banks in China, Japan and all around the world. Just like the dollar bills you use every day.

What makes this paper worth something is the trust that the government will pay. If the government were to actually default on the Social Security trust fund bonds, it would destroy confidence in government bonds, and would be an unprecedented disaster for the world economy. After all, if the politicians in Washington were to stiff senior citizens out of their retirement, why should China trust that it will get paid?

With the soaring budget and trade deficits, the dollar is already taking a beating in overseas markets, and those countries holding Treasury bonds are getting nervous. There are rumblings from several Asian countries that want to diversify their holdings in case the dollar falls even further.

For the president or others to even bring up the idea that government IOUs are worthless can only make these foreign banks even more nervous. And if any of these countries breaks ranks and starts dumping dollars, then you could see a calamity on the order of the Great Depression. Interest rates would soar, as would inflation on consumer goods. This combination would cause the real estate market to fall, thus endangering the biggest investment for most families.

Besides the financial peril, there is no politician dumb enough to tell seniors that the government isn't going to honor its commitment to them. It would be a political death sentence that could take down an entire political party.

It's safe to say that the government will not default on these IOUs. But that doesn't mean there are not serious problems with the Social Security Trust Fund, which I will cover in Part II.

The Social Security Trust Fund, part II

Spending the surplus

"Deficits don't matter." -Vice President Dick Cheney, to then-Treasury Secretary Paul O'Neill in 2002 to justify another round of tax cuts.

Though the naysayers might be wrong about the non-existence of the Social Security Trust Fund, there are real concerns that we should not take lightly.

The fundamental problem with the trust fund was created in 1983 when the system was reformed, following recommendations by a commission headed by Alan Greenspan, the current chairman of the Federal Reserve.

The plan was to raise payroll taxes and build up a large trust fund to cover the retiring Baby Boomers. The surplus money would be invested in Treasury bonds, which could be redeemed when the amount of funds coming in were outpaced by those going out.

Seems simple, right?

This is where the real fun starts.

President Ronald Reagan was not a big fan of raising taxes. But with Social Security on the brink and not enough political support to make it a voluntary program as he wanted, he relented.

However, he did get something out of this deal.

Because the trust fund had to invest in special Treasury bonds, that surplus cash flowed into the general fund in exchange for those IOUs. This in turn helped make his administration's burgeoning budget deficits look smaller.

And it has done the same for every president since.

In fact, even when there is a budget surplus, as there was during the Clinton years, the government still spends the surplus payroll taxes and issues more Treasury bonds to the trust fund.

However, there is a day of reckoning, and it's coming up fast.

It is estimated that in 2017, the government will have to dip into the trust fund to meet its obligations to Social Security recipients. To do this, it will have to cash in bonds, which means it either has to take money out of the general fund or borrow it from someone else.

With large budget and trade deficits continuing on into the foreseeable future, meeting these obligations will become exceedingly difficult.

Despite what Vice President Cheney said, deficits do matter. The real problem with the Social Security trust fund is the federal government has been living on borrowed money for far too long. In 2017, those people who loaned it to them are going to start wanting a return on their investment.

Any talk of "saving" Social Security that doesn't include real deficit reduction is a waste of breath. You cannot separate these financial realities.

Social Security isn't the failed Ponzi scheme some would like you to think. The basic premise works very well. But the mistake was in investing the trust fund in government bonds, when those running the government had no commitment to sound fiscal policy.

It's the government's general fund that's insolvent, not Social Security.

President Bush is right when he says there is an urgent problem. He's just pointing the wrong way.

But how do we fix this mess? We will take a look at a variety of solutions in part III.

The Social Security Trust Fund, part III

How to fix this mess

Let's just say that investing Social Security funds in the stock market is not a bad idea. In fact, it's a pretty good idea.

But I'm not talking about the personal accounts President George W. Bush has been pushing.

In the first two installments of this piece, I talked about what the Social Security Trust Fund is, and the problems it faces. Now is the time to come up with some solutions.

First, as was made clear in part II, you have to fix the budget deficit. Without that, nothing the government does will work. It's just that simple.

As for the trust fund itself, the number one problem is that it has been badly invested. As any good investment advisor would caution, never put all your eggs into one basket, and be sure the companies you invest in have a good likelihood of being profitable.

Since all of the trust fund was invested in special-issue U.S. Treasury bonds, we flunk on both accounts.

The current caretakers of the federal government are interested in spending money, not making money. The trust fund was an easy way to spend what they wanted, while cutting taxes at the same time. This made for good politics, but not policy.

If, like a host of state retirement systems, the trust fund money had been invested in assorted stocks and bonds, there would be no trouble today. The federal government would not have had access to the surplus cash flowing in from payroll taxes, and in turn would not be facing the daunting task of repaying it.

Even if the market had performed poorly, it would have been better to keep this money out of the hands of Congress and the president. Heck, storing it in a mattress might have been the better option.

While we can't do anything about yesterday, we can change what is happening today. If the trust fund were changed to allow the kind of investments state funds use, we could stop the reckless spending of the surplus.

There could also be an effort over the next 20 years or so to pay off a little of the debt the government owes to the trust fund, which would then go into the new investment fund. It could do this by cutting spending, getting rid of the recent tax cuts, or more borrowing, probably a combination of all three.

It would be tough, but little by little, the government could bail itself out of this mess.

Some would say that instead of having the government invest the money, it should be handed back over to taxpayers in the form of personal accounts.

But no matter how great Bush and his people say this is, it ignores the basic structure of the Social Security system. It operates like an insurance policy, not a 401(k) account. If money is yanked out of the system to create private accounts, then the government would have to borrow money to take care of today's retirees. This would make the current debt problems far worse.

Also, having professional fund managers, like those who run the state systems, would be a better deal for all but the most savvy investor. The overhead costs would be much lower, and they would have better access to information, and the power to make better investments not open to individual investors. If the managers do a good job, it would extend the life of the fund past the projected 2041 insolvency date.

The Social Security system needs to be fixed. But what needs the most help is what is getting the least attention. That's because the people promoting these changes are the very ones to blame for the system's sorry condition, and they would rather not admit to their malfeasance.

It will be difficult to fix the system now, but it will only get harder down the road.