One of the topics we’ll start hearing a lot more about in the months ahead is the need to “rein in spending on entitlements.” You’ll hear many arguments about the percent of the budget taken up by entitlements, blended with a GOP chorus on the existential threat of the budget deficit. It’s a well understood political kabuki dance that is so filled with falsehoods one wonders where to begin. For the purposes of this article I’m going set aside the chimera of the deficit and leave it to future articles to deal with that particular campfire ghost story. What I want to tackle here is the basic notion of “entitlements” with a specific focus on distinguishing between “insurance” and “welfare.”
What very few people understand is that Social Security is an insurance program, not a forced savings program, nor a Ponzi scheme. So, what does that mean, exactly? It’s a financial instrument, like a deed or an equity, that has a mathematical form that, unlike most such instruments, explicitly deals with shared risk, uncertainty and variance. OK, so, what the heck does that mean?!
Let’s use a completely fictional thought experiment to illustrate the basic structure. Imagine a country with only ten residents. This nation has eradicated all diseases with one notable exception. Everyone has a 10% chance of catching this one disease and it is fatal, but also curable, though the cure costs $100,000. What do the people of this nation do? Here are the options:
1. Do Nothing — This is pretty irresponsible. Someone is going to get the disease and unless they manage to come up with the $100,000 they will die. This option basically cedes the outcome to the disease and chance.
· Cost to each citizen = $0; Total cost = $0; but someone is likely to die.
2. Focus on Personal Responsibility — Under this option everyone is expected to manage their own affairs responsibly and, since everyone has a chance of getting this disease, they must each set aside $100,000. Assuming everyone can do so, that means our tiny nation will have set aside $1,000,000 for a problem that should only cost $100,000. Collectively, it involves spending ten times more than is financially necessary.
· Cost to each citizen = $100,000; Total cost = $1 Million and nobody dies.
3. Set up an Insurance pool — Under this option everyone gets together and agrees to chip $10,000 into a pool which will be available to whoever actually gets the disease. Collectively, the nation’s spending on the problem matches the scale of the problem exactly and everyone has assumed a shared burden that matches their shared risk.
· Cost to each citizen = $10,000; Total cost = $100,000 and nobody dies.
What’s going on here is simple. Under the very expensive second option we have failed to take mathematical advantage of the variance in the outcome of our shared risk. Yes, someone will get it, but they won’t all get it. Expecting everyone to cover their individual risk without enabling that to be balanced by the rest of the collective distribution guarantees a massive over allocation of resources. The real world is obviously far more complex than this simple thought experiment, but underneath all that complexity the core financial logic remains.
Now, what happens if we assume that not everyone in this tiny nation can afford to set aside $100,000. In fact, let’s assume that one of our citizens can only afford $10,000. What happens to each of our three options in that event?
1. Do Nothing — Nothing really changes in this case. Everyone still faces a 10% chance of dying from the disease. We do know we have at least one citizen who will certainly die if they catch it.
· Cost to each citizen = $0; Total cost = $0 but someone is likely to die, and that probability has gone up.
2. Focus on Personal Responsibility — This is far more interesting. There are two possible ways of adjusting this strategy to address the simplistic inequality I’ve postulated. On the one hand, Case A, the person who is unable to raise the needed resources can be treated as an economically failed pariah and simply allowed to die if they get the disease. On the other hand, Case B, we could decide to place an additional tax burden on the nine citizens who can afford it. By taking $10,000 from each of them and then adding that $90,000 to the $10,000 our less advantaged citizen can personally muster, we ensure that everyone has the needed $100,000 set aside. This is a “welfare” structure that redistributes resources in order to achieve a socially desirable objective.
· Case A: Cost to each wealthy citizen = $100,000; Our poor person spends nothing, because there’s no point; Total cost = $900,000; None of the wealthy folks face any risks, but our poor person has a 10% chance of death.
· Case B: Cost to each wealthy citizen = $110,000; Our poor person sets aside $10,000; Total cost = $1 Million and nobody dies.
3. Set up an insurance pool — No changes to basic structure nor to the risks faced by our citizens. In this case, there’s no need for any welfare or redistribution to ensure everyone’s risk is covered.
· Cost to each citizen = $10,000; Total cost = $100,000 and nobody dies.
Now, I admittedly picked the numbers in my example to accentuate the differences I’m trying to highlight. The real world is never this clean and some of those real-world complexities will muddy the waters. However, the key lesson here is that these different socioeconomic options produce radically different financial results both at the individual and collective levels. Specifically, when there are shared risks or uncertainties with a wide economic variance in outcomes the only sensible financial instrument to use is insurance. It will consistently provide the optimal outcome against the risk at the lowest collective and individual cost.
Also, note that, far and away, the best option for our wealthy citizens is shared insurance and the worst is to emphasize individual responsibility against a shared risk amid the realities of economic inequality. Not only does the latter cost them ten times more than they should have to pay, it also pushes them into choosing between reckless indifference towards others or an increased tax burden required by the economic inefficiencies of that strategy. The next time you hear a GOP rep waxing on and on about personal responsibility against shared risks recognize that for the economic stupidity that it is.
With that foundation let’s turn to Social Security. There is a risk we all share which is having access to adequate financial resources once we reach the point we can no longer work and for as long we live beyond that point. Some of us will get injured or fall ill and find ourselves unable to work well before we planned to retire while others will continue to work into our 60’s or 70’s. Some of us will die prematurely while others will live into their 100s. None of us can know for certain what our future will entail. Social Security is the insurance program specifically established to address that reality.
Unlike my binary thought experiment where the disease was either fatal or cured and the medical cost was either $100,000 or zero, our retirement needs are far more complex and varied in scale. There’s a huge difference between ensuring everyone has access to enough resources to survive vs live a middle-class lifestyle vs living in the lap of luxury. Social Security is aimed at providing the foundation we all need. Beyond that, it remains up to each of us to earn and save enough to achieve our personal aims.
However, as we do so we lose the financial leverage on our resources available through shared insurance pools. We only lost this leverage over the last few decades. Both pension plans and defined benefit plans are structured financially to leverage the same kind of variance math I’ve highlighted in my insurance example. In contrast, a defined contribution plan is just a gussied-up savings plan. They’re certainly better than nothing, with employer matching and tax breaks, but they do not take advantage of any of the shared risk variances that generally provide substantial additional mathematical leverage.
So, Social Security is a financial instrument we’ve each either purchased or are in the process of purchasing. This instrument is designed to exercise the mathematical leverage present in the wide variance in economic needs we all face at the end of our years. It is not a welfare program, nor some sort of “benefit” program. It does not “take” from the wealthy to provide benefits to the poor. It’s not “socialism” whatever that means. It’s a collective agreement on the most economically efficient means to address a common purpose around a shared uncertainty. Stripped of ideology it’s just the best financial tool for the job.
Unfortunately, we don’t live in a world in which people readily look past their ideologies. Note the key phrases in my description. In addition to the math, “collective agreement,” “common purpose” and “shared uncertainty” are all essential concepts to understand the financial structure behind insurance. In the highly ideological world of the GOP those all bring angst if not anger. They have real trouble whenever confronted with any common purpose and anything “collective” or “shared” generates a hostile knee-jerk reaction. They also have no idea that their political demands generate the worst economic outcomes both for the nation as a whole and their primary constituencies.
Which brings us to the term “entitlements.” When we refer to Social Security as an “entitlement” there are two possible meanings of that word. On the one hand, as the purchaser of this financial instrument, I am “entitled” to use it for the purposes for which it was designed. I own my rights to my share of that resource pool as set out by the actuaries in the Social Security administration. In that sense, I’m “entitled” to it because I bought it.
But, that’s not what most politicians of either party mean. They really do not understand the points in this article and have convinced themselves Social Security is just some government program that undeserving people think they have some “entitlement” towards. From their perspective it’s welfare, which wealthier folks may or may not decide to continue granting to all us undeserving bums. They really do not understand what insurance is, nor the math behind how it works so the only options they can fit within their socioeconomic conceptual frameworks are “do nothing” vs “personal responsibility.” And, not only does that latter strategy drive both collective and individual costs through the roof it also raises the personal dangers of our shared risk for most of us and drives politics towards welfare and redistribution debates.
All this confusion and lack of understanding has led politicians of both parties to mismanage the Social Security program for decades. It’s routinely mixed in with welfare and redistribution programs even though it’s a completely different socioeconomic construct. The entire language around “entitlements” has become detached from the realities of the program. As a result, Social Security does have real problems at this point. Those are all solvable but only if we restore our understanding of its underlying insurance fundamentals.
So, is Social Security an entitlement? Not as generally meant by that term. It’s a national insurance program and each of us is entitled to the resources for which it was designed. It needs new actuarial work on life expectancy and lifestyle needs; and it should be expanded to extend its specific mathematical leverage to more of the income earned by higher wage brackets. But, it’s not some benefit program subject to the whims of politicians, nor is it something vying for resources with other programs managed by our national government.
Social Security is a concrete foundation to our social contract and our rights to that insurance policy, which we have each enjoined and procured, are as important to protect as any other major financial instrument, asset or property.