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SAug 11, 2010

Social Security Funding: Yes, It’s Complicated

Scott Burns

Q. Some time ago you wrote a column about possible proposals for Social Security 'modernization.' Why is it that nobody, but nobody, talks about raising the earnings cap on the employment tax? Why not raise the cap from $106,800 to at least $300,000? It seems that the middle class is asked to carry the largest part of the burden to support the program.

Also, why haven't we passed a bill that would protect the employment tax revenue and provide us with a truly funded pension account? —E.C., Boston, MA

A. One of the options in the recent Kohl report is to raise the wage base cap. Having it cover all earned income, for instance, would eliminate the unfunded liability. Since 94 percent of all workers earn less than the $106,800 wage base cap, it is not surprising that most people think raising the cap is a great idea.

While middle income workers pay the bulk of all employment taxes, it is often forgotten that the higher income workers don't get any benefits for income over that $106,800 limit. Instead, they have to save and take their chances on its growth.

More important, taxing all earned income would create new problems even as it solved the funding issue. Add the full burden of the employment tax to the 35 percent income tax rate high income professionals pay, and those workers will be paying at a 50 percent tax rate. While it is easy to imagine a $5 million a year baseball player paying 50 percent in income taxes, it's not so easy when you start thinking about young professionals in high cost urban areas.

Consider the example of a young doctor. If she goes to medical school she will probably complete her training with about $150,000 in debt. Paying that debt off will require earning $300,000 because she will have to pay $150,000 in income and employment taxes to net $150,000.

When that doctor thinks about educating her children the same thing will happen. To send her bright daughter to MIT, for instance, will cost $53,000 a year at current prices. That means a total bill over $200,000. This will require earning over $400,000 since she'll have to pay $200,000 in income and employment taxes.

So she'll need a total of $700,000 in earnings just to repay her medical school education debts and provide one child with a private college education. Burdens like that could make all those jokes about doctors who became plumbers come true.

Securing our employment tax payments is a complicated issue because the amount of money involved is huge. Basically, it would overwhelm the financial markets, so there isn't a good answer. The total value of the U.S. equity market, for instance, is about $11.5 trillion. The Social Security Trust fund is about $2.5 trillion. The unfunded liabilities of the Social Security program were another $5.7 trillion in the 2009 Trustees report.

Living a long time is a good thing, but it has consequences.

Some of the best research in this area is being done in Boston— Alicia Munnell at the Center for Retirement Research at Boston College, Jim Poterba at MIT, and Laurence J. Kotlikoff at Boston University. I've written two books with Kotlikoff, including "The Coming Generational Storm" (MIT Press, 2004).

Q. I am interested in life annuities to supplement my retirement. Would you recommend this as the sole strategy? Also will the returns be higher if interest rates rise? Should I ladder them— for example buying $100,000 at a time? I am 67. —L. K., by email

A. I would not recommend life annuities alone. Remember, a life annuity means you no longer have control of your principal. You have exchanged it for a contract that provides a monthly income for life. A retirement strategy that includes both an investment portfolio and life annuities, however, has been shown to improve the odds against going broke.

Prevailing interest rates have an impact on life annuity payments. They were much higher when interest rates were 10 percent, but inflation was running at that rate too. You had more current income, but your long term purchasing power may have been lower.

Laddering life annuities is a good idea. It will do two things for you. First, if interest rates rise, it will increase the amount of your annuity. Second, your annuity will rise anyway because you'll have lived another year, and your life expectancy will be shorter.

Filed Under: Q&A (from print), Social Security