September 2005

Social Security: A Cross-Generational Wage Swap

“To a certain degree, Social Security could be considered a cross-generational wage swap. Using this scenario, the first year of a young person’s career overlaps with the first year of an older person’s retirement. Wages typically increase over time, and theoretically this is how Social Security is able to provide a return on investment. For example, a fixed percentage on the standard wage of a carpenter will be worth more today than the same percentage on a carpenter’s wage 40 years ago. Therefore, Social Security has been able to provide inflation-protected returns on contributions to the system.” (AEA Letter)

The financial strength of Social Security is very dependent upon employment rates and economic growth. In fact, the Social Security system was designed to benefit from gains in the economy while protecting its participants from undue risk. Our contributions to the system are simply a passive investment in the future of America and American workers. Therefore, even though Social Security is a “pay-as-you-go” system, it is still able to provide a completely legitimate investment return.

Furthermore, the returns on Social Security contributions are influenced by some of the same factors that affect stock market returns. The only difference is that the stock market places a much greater importance on the profit of the corporation than on the profit of the worker. Not to mention that stock returns are rather volatile, and the cost of transitional financing for private stock accounts negates the fact that stock returns have typically outpaced wage growth. This is one of the main reasons why a conversion to private stock accounts would be unwise.

At this point, the future risks for traditional Social Security and private stock accounts are roughly equal. The determining factor involves the decline in the workers to beneficiaries ratio. This decline will cause substantial negative money flow out of the stock market as people begin to liquidate their portfolios in order to finance their retirements. In fact, the positive money flow from the working Baby Boom generation caused stocks to become overvalued from a value perspective. Therefore, it is reasonable to assume that stocks could experience an extended period of lackluster gains, which would allow prices to return to historical valuations.

While the retirement of the Baby Boom generation should have a negative impact upon stock returns, it may actually accelerate wage growth. During the course of a working career, people traditionally earn promotions that in turn increase their incomes. It should go without saying that the higher paying jobs are usually held by the more experienced workers.

However, many companies will soon face a problem of demographics. They will need to fill positions held by members of the retiring Baby Boom generation, and this should create strong demand for qualified younger workers. If the economy is handled in an intelligent manner, this situation could serve to accelerate wage growth. This is because the working generation would be in a position to earn promotions at a faster rate than previous generations.

From a Social Security standpoint, wages will probably provide a better return on investment than stocks after adjusting for the cost of the transitional borrowing needed for private stock accounts. Therefore, it actually makes more sense to stick with the traditional “pay-as-you-go” system while making adequate provisions for future generations.

Another point to consider is the fact that most people rebalance their portfolios as they near a retirement age. This typically involves switching to more conservative investments such as bonds. Therefore, there will soon be many people looking for fixed income investments, and this should create additional demand for the PACT America proposal to refinance the national debt. Private stock accounts would create a conflict of interest between generations, but the PACT America program will continue the system of cross-generational interdependence.