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As a self-employed business owner, I am paying approximately 15% of my income to social security, yet I keep hearing that they're "running out of money for it." I'm a little confused about this: 15% is how much I currently save for retirement and over 25-30 years, it should fund my retirement comfortably and that's at a rate of around 8%.

I realize social security isn't invested in anything returning 8% or higher, but it's hard for me to imagine that they government is running low on money with my 15% of income (if I always made 60000 I would have paid 270000 into social security and at 3% interest, that's 8100 a year).

So where is my social security money going?

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A common popular argument is that they are going toward paying current beneficiaries because earlier in time the government allowed the social security trust funds to flow into the general fund (of the US Federal government). This is a flawed argument because it presumes that the Federal government would not have borrowed the same amount of money from elsewhere had the funds not been invested in US government securities.

In essence, the government borrowed the social security trust's funds, and owes them back. Therefore, in essence, the trust fund is invested in US government securities.

The particular instruments are special issue securities that are not bought and sold other than between the US Treasury and the SS Trust. This an ongoing daily transaction activity where newly collected revenue is used to purchase special securities, and special securities (principle and interest) are redeemed to just cover Social Security payments.

The Social Security Trust funds earn much lower returns than your 8%, the rate of return is calculated by a particular formula. Since 1960 the formula has been based on a monthly calculation of average market yields of open market US Treasury securities. Effective rates have fluctuated between just under 4% to almost 12% historically. Rates have been below your 8% benchmark since the mid 90's and are currently at historic lows due to a few decades of US Treasury average rates trending downward.

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There are two ways to organise social security. One scheme is known as fully-funded social security. The alternative is called pay-as-you-go.

Fully funded schemes

Under a fully-funded scheme, the government collects regular payment from each member. These payments are invested until the member needs to claim (e.g. their pension), at which point the member receives payments from the invested money and the returns that it has generated. This corresponds to the situation you describe where your social security payments are sat in an investment somewhere waiting to go back to you.

Pay as you go schemes

This may be disturbing reading, so brace yourself!

Countries such as the UK and the USA do not use a fully-funded scheme. Instead, a significant portion of their social security provision operates on the basis of a so-called pay-as-you-go scheme in which the money paid by today's workers (e.g. you) is not invested at all. Instead, it is immediately spent on making social security payments to people who are currently retired. The hope is that today's workers, when they eventually retire, will likewise have their pensions paid from the social security contributions of their children (who will by then be working). And so the chain continues, each generation handing money directly to the last with little provision for self-sufficiency.

Assessment

The obvious problem with this is that the generation of 'boomers' now retiring is unusually large and had unusually few children. Moreover, that generation enjoys unprecedented levels of longevity, meaning that they are likely to claim far more out of the system than they paid in. All this means that current workers face a large burden paying the social security claims of the much larger generation that preceded them.

However, we are kind of stuck. If we want to switch to a fully-funded system then somebody has to get a very bad deal. Option 1: current employees have to pay twice (for their own fully-funded retirement and for the pay as you go claims of their parents). Option 2: current workers pay only for their fully-funded retirement and current retirees (who already paid for their parents' pensions) do not receive any pension at all. Neither alternative is very politically tractable.

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    $\begingroup$ Pay as you go schemes also have their advantages. Intellegent schemes enforce the link between current and future generations. Forcing current generations to invest more in education for the younger and so promoting long term growth. users.ugent.be/~tbuyse/2011025.pdf is an interesting paper on the subject. $\endgroup$ – Stinky Nov 20 '15 at 18:20
  • $\begingroup$ @Stinky Yes, it wasn't my intention to imply that PAYG is unambigously bad—although, rereading what I wrote, I can see why it might give that impression. $\endgroup$ – Ubiquitous Nov 20 '15 at 21:11
  • $\begingroup$ But did all of the boomers' contributions to PAYG fund go to their parents? When the ratio of young/old generation is high there could be surplus in the fund so it could be "partly funded", as there would be deficit for the contrary. Maybe that can serve as some kind of cushion for bad times? $\endgroup$ – Eric Mar 19 '18 at 10:45
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    $\begingroup$ @Eric, at least for the UK's experience: unfortunately, the UK government does not have a ring-fenced 'PAYG fund' (pensions are paid out of general taxation). That means any taxes paid by the baby boomers in their prime working years are long gone and not available to fund future pensions. You are right that a sensible scheme might try to 'smooth' variations in cohort size by saving income from large cohorts. Alas, politicians get elected by giving tax cuts today, not by raising taxes to pay for (someone else's) pensions tomorrow. $\endgroup$ – Ubiquitous Mar 19 '18 at 15:55

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