Social Security vs. Pensions

After the discussion in class the other day about the political problems with entitlements for senior citizens. KT asked whether social security would be better if it was privitized like a pension.

This is an area where folk macroeconomics isn't bad, but it can be misleading.

The argument usually made is that pension funds can generate a bigger nest egg for retirees to live off of, that isn't matched by the checks sent out by the Social Security Administration. 

What I would say to that is ... that's true, but they're not the same thing, so why would you compare them at all? This makes that a form of straw man argument.

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So what is a social security program (and Medicare too). These are pay-as-you-go or cash-in-cash-out systems. Collections are made from some part of the population (like workers) today, and immediately divided up and given to some other part of the population (like retirees). 

There is nothing inherently wrong with this sort of system, and it mimics how families have taken financial care of elders for much of history.

Interestingly, since there is no investment in a social security system, other than having babies that grow up to be new payers, the (gross) rate of return is roughly the rate of population growth. Since people are real rather than nominal, that's a real rate of return. 

The problem I described in class, of the relatives size of the two groups changing through electoral methods, alters that rate of return. It typically  lowers it , since most people want to get out of the paying group (reducing its rate of growth). An additional problem is that as people get richer, they tend to have fewer children, reducing the growth rate.

Some pros of this sort of system is that it can always work, and it's relatively efficient. The cons are changing demographics, and unethical voting.

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On the other hand, a pension fund is one in which workers pay into an account today, that invests the money, and then pays out the proceeds many years later. That investment may have a degree of control for the investor, although that is sometimes illusory.

The "rate" of return on this sort of investment can be quite high. There are two caveats to that. One is that some people invest timidly producing lower returns to fund their retirements. The second is that most of think of these a nominal rates of return. So we need to subtract out expected inflation from the if we're going to compare to social security.

The pros of this sort of system are the higher returns, and thus higher income when old. The cons are that investments aren't always good, and returns can be stolen or mismanaged.

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The takeaway from all this is that social security and pension fund systems are separate things. Why not have both? In fact, that is the case for a majority of people in developed countries. 

The common argument always seems to be to turn social security into a pension, rather than the other way round. This is usually based on rates of return. But that's just one aspect. A forgotten one is that if social security invested like a pension, the Social Security Administration would become the largest investor in the world. How do you feel about its ability to do a good job? How do you feel about it being the dominant investor in most firms, probably with a seat on the Board of Directors of every large corporation?