Saturday, July 16, 2011

Fixing Social Security - The Private Lockbox

I wouldn't go so far as to say Social Security is broken, but it sure could use a few improvements.  Some say that funds collected for Social Security should be stored in a lockbox to ensure that people receive payments when they retire.  Others say that funds collected should be invested in risky private ventures so as to increase the rate of return.  What I propose is a mixture of these two ideas: the Private Lockbox.


Let's do a simple test.  For this exercise, all you need is the latest Social Security Statement the government sent you.  (It's usually a four page document with green lines on it.  It says "Your Social Security Statement" at the top.)

I've created this spreadsheet (created on a Mac - no viruses) that will allow you to type in your information and see how well Social Security will perform for you.  The spreadsheet presents an alternative scenario where: instead of your money going to the government, it is placed into an interest bearing account.  When you retire, the account pays your benefits.  This alternative scenario allows you to compare.  If you run out of money before you die, then Social Security as it stands now is the better deal for you.  If you don't run out of money, then you would be better off investing your money yourself.

Here's how to fill in the spreadsheet.  (Note that this spreadsheet isn't meant to be printed out.  If you really want to print, you will have to setup up the print layout yourself.)
  • In cell B1, type the year you were born.  (Don't lie - no one's going to see this but you.)  
  • In cell B2, type how old you want to be when you retire.  You only have three choices: 62, 67, or 70.
  • In cells F3 through F5, type the promised Social Security monthly benefits as spelled out at the very top of page 2 of your statement (Retirement section).  You should see different benefits for ages 62, 67, and 70.
  • In cells C9 and down, type the "Your Taxed Social Security Earnings" numbers from the very top of page 3 of your statement.  Copy those numbers exactly as they appear, and be sure to match up your wages with the correct year.  The spreadsheet starts at age 14.  If you worked before then, just leave out those early years and fill in your wages starting with the year you turned 14.
  • In cell J1, type the wages you made in the last year listed on your statement.  This replicates their assumption that you keep making your last year's wages until you retire.
  • Finally, check cells C9 and down again.  It should show that your last year's wages continue until you retire.  If it looks messed up, copy and paste the correct numbers and/or just type those wages until it looks right.
Now that you have the spreadsheet filled out, are you ready to have fun?  Let's start off with 0% interest.  In cell B4, type 0%.  And for retirement age, let's type 67 in cell B2.  With 0% interest, you simply put money in the bank.  It doesn't earn any interest, and you start taking the money out when you retire.  Column F shows the balance in your savings account at the end of each year.  When that goes negative, you've run out of money.

In the example that comes with the spreadsheet, this poor person (we'll call him Bob) runs out of cash at age 80.  When I type in my personal numbers, I run out at age 79.  I suspect that you will find in your situation that you would run out of cash about the same time.

I don't know about you, but I intend to live older than 80 years.  I wouldn't want to run out of savings.  At 0% interest, Social Security is the better deal.

Now let's change the interest rate in cell B4 to 1%.  This is a decent interest rate.  When do we run out of money?  Bob runs out at age 83.  I also run out at age 83.  This is probably right at the life expectancy of someone who makes it to 67 years old.  Though I want to live beyond 83, this looks like a breaking even point.

How about 2% interest?  Bob runs out at age 89 and so do I.  This is starting to push it.  I don't want to get too wrinkly.  The savings account is starting to look better than Social Security, but not by too much.

Now let's try 3% interest.  Bob and I run out at age 103.  There's no way I'm living that long!  I'd definitely choose the savings account alternative.

Something funny happens at 4% interest.  Go ahead and type that into cell B4.  After Bob and I retire, our savings account is GOING UP.  This is because the interest alone on our savings is enough to support the benefit payments.  We will never run out of money!  Do I think I could find a safe long-term investment that can return 4%?  Um ... yeah!  Social Security is left in the dust.  (Watch that some of you comment to me that your personal numbers don't show this.  Just let me know and I'll stand corrected.)

Finally, if you keep in mind that the average long term returns on the stock market are 12%, go ahead and type that number into cell B4, and see what you get.  Bob becomes a multi-millionaire!

From this exercise, I estimate that Social Security's rate of return is somewhere between 1% and 2% (and that may be a little generous).  I don't know about you, but I think I could do much better on my own.

I feel as if the government has forcibly taken a few talents from me (excuse my Bible reference), and have buried them in the ground. If I live long enough, I'll eventually get them back.  But what good will they be?  There's no way I'll be able to live off of my Social Security check alone when I retire, and it feels like I've put so much into it.

Though Social Security promises a steady monthly check, it's my opinion that as it is now, it is an inefficient solution to providing security for our elderly.


There are two main solutions which would work.  #1) Do away with Social Security altogether.  OR #2) Introduce higher returns.

Solution #1 just isn't going to happen.

This leaves Solution #2, which means investing in the private stock market.  That's the only way to get higher returns.  However, this introduces risks.

For example, during times of plenty, Grandpa Sam could be rolling in the Social Security dough from his investments and come out a millionaire.  And then when the next market crash comes (and it will come), Grandma Julia loses all her benefits.  This doesn't seem fair, seeing how they put the same amount of their hard-earned cash into Social Security taxes.

We can have both the security and the high returns by using a plenty/famine approach, much like the story of Joseph and the grain in the Bible.  During seven years of "plenty," Joseph collected grain from all sources.  Then when seven years of "famine" came, he was able to distribute the stored grain (at a profit - no doubt) and help everyone survive.

Likewise, let's say that the stock market earns an average of 12% a year in the long-term.  Let's choose a guaranteed return of 6%.  When the stock market's doing well, the government would store the excess earnings in a very large contingency reserve (a fancy term for lockbox).  When the stock market crashes, the government would dip into the contingency reserve to pay out the same level of benefits.

Could we use a 6% return on what the government takes in Social Security taxes?  Let's look at Bob's situation.  If he retires at 67, he's only going to get $1,250 a month.  That doesn't buy very much.  At 1.5% interest, the savings account scenario runs out of cash at age 85, which is well beyond the life expectancy.  At 6% interest, Bob's benefit can be raised up to $4,700 a month to get the same results.  Now that's something I could live off of when I retire.

If the government could somehow guarantee an 8% return, then Bob could raise his benefit to a whopping $8,500 a month.  Wow!  At 12% (unreasonable and too risky to guarantee), the benefit goes up to $28,600 a month.


This analysis of mine is nowhere near perfect.  There are other concerns I don't consider, such as the idea of government controlling private stocks.  This could be somewhat offset by disallowing voting rights to government entities.

Also, there's the issue of having such a large Social Security contingency reserve while other funds are suffering.  I could see a large temptation to dip into the reserve to fund other projects.  This could be offset by setting an upper limit on the contingency reserve.  If the reserve ever gets tapped out, the excess "excess funds" could be allowed to go to other budgetary needs.

Even if we were to begin now with such a plan, it could take decades to build up the contingency reserve.  If a large market crash happens too soon, the government could be looking at a major loss.  This risk can be easily mitigated by easing into higher returns.  That is,  now we're getting around a 1.5% return.  We can raise that to 2% for a couple of years.  (Everyone's benefits go up.)  If the stock market's doing well, then we can raise it to 3%, and so on until the contingency reserve is sufficiently large to support a 6% return (or whatever the magic number is).

Also, my analysis includes the employer-paid portion of social security taxes.  Not only does this represent the total money that the government collects, but it also represents (in a perfect market) the higher wages the employer would pay if no Social Security taxes were taken out at all.  In actuality, if Social Security were to disappear, your employer probably would not pass on the full 6.2% savings to you, but rather give you a slightly lower raise.

Finally, this proposal does have the added benefit of putting more money into our economy through investing in private businesses.  This has to be a good thing, especially if it produces more jobs and even higher returns.  Sure there would be a lot of fine details to iron out, but I'm sure the fine men and women of Congress could figure it out.  To me it seems a no-brainer that this proposal is the way to go.

    Aspiring Writers Can Deduct Business Losses

    There's a first time for everything.  Since I put in sufficient money into forwarding my fledgling writing career in 2010, I can actually deduct business losses.  This is a good deal for the starting aspiring writer.  (But also keep in mind that once you start making money, the IRS will get their payback through self-employment taxes.)

    And since I'm an actuary, I chose to do my taxes on my own (as I do every year).  I had to learn how to fill out these new forms: Schedule C (Profit or Loss From Business) and Form 4562 (Depreciation and Amortization).  It took me several hours this week to figure it all out.  Perhaps some of the knowledge I've gained can help you fill out your own Schedule C/Form 4562 more quickly.

    This article gives the best advice I could find on the web.  It contains general tax advice geared directly to freelance writers.

    Okay, let's look at Schedule C.  I put my name and SSN at the top.  I enter:
    A) Freelance Writer (you can put whatever title you want here - just make sure it sounds business-y)
    B) 711510 (the code for artists/writers)
    C) blank - I am my own business.
    D) blank
    E) blank
    F) Accounting method = Cash.  This means that I will account for all income in the year that I receive it (instead of stretching it out over several years).  For expenses, I'll do the same, with some exceptions noted below.  "Accrual" is meant more for people that buy and sell a whole bunch of stuff.  Most writers will use "Cash" accounting.
    G) Yes, I materially participated in my business.
    H) I just began my business (started getting serious/going to conventions/etc.), so I check this box.

    Part I) Income - I didn't receive a dime for writing in 2010, so this section is one big fat zero.  (Warning, if you go five years without reporting a profit in at least three of those years, the IRS may come after you and try to make you pay back these taxes.  Hey, if I don't start selling to magazines/etc. by then, they can have their taxes back!)

    Part II) Expenses - Okay, everything above this section was easy.  To fill out this next part, you just need to know what all your expenditures were, and what category you want to put them in.  (There seems to be a little variation as to where different people put things, but it all adds up to line 28 in the end.  Just be consistent where you put things year to year.)

    This is where I put stuff:

    #8) Business Cards.
    #9) Mileage for using car (I only put in mileage to the conference I attended.  It wasn't worth it to include the 1 mile trips to the post office - but if you keep track of that kind of stuff, this is where it goes.)  This year, the mileage rate is $0.50 per mile.
    #13) Depreciation - see instructions for Form 4562 below.
    #18) Postage and paper supplies.
    #22) Other supplies (like the cool moleskine my wife bought me).
    #27) See Part V below for a list of "Other Expenses".

    A note about line 30: Most of what I found on the web seems to indicate that writers don't take the time to calculate the business use of your home.  It's a lot of work for very little return.  I just put zero like all these other folks.

    #32) A confusing line.  Most of us will check 32a (all investment at-risk), which is what you're supposed to check unless you happened to invest your money in certain not-at-risk investments (listed in the IRS instructions).  Chances are, none of us will ever do that in our writing business.

    Part III) Skip.

    Part IV) Since I claim mileage expenses in line 9, I answer all the questions in this part.  I estimate my total 2010 mileage on my car.  I write down the conference round-trip mileage, estimate commuting to my day-job (52*5*round trip mileage) and subtract to get "Other".  About the commuting miles, I considered writing "0", as I don't commute to my writer's business.  But since the IRS instructions say, "commuting is travel between your home and a work location," I take that to include my day job.  In either case, it doesn't affect the deduction.  Only the business mileage is deductible.

    I answer questions 45-47b all "Yes".

    Part V) There are certain expenses that don't go into the Part II categories.  Here I list:
    Conference Fees
    Membership Dues
    Subscriptions to Trade Magazines

    I could also add books that I've bought for "research", but I have to admit that I bought those three books for fun.

    Note that since there is no Income for me, I end up with a negative number in line 31.  I have a business loss, which directly reduces my AGI on 1040.  That's good, as it means less tax liability and a bigger refund (or lower payment).

    Okay, now let's look at Form 4562, which you need to fill out line #13 above.

    Now, this is the hard form.  This is the scariest thing I've ever seen in my life.  This is what makes even the smartest actuaries cower like little babies before going down to H&R Block.  What's pretty sad is that the math behind the form is pretty basic stuff.  It's just knowing where to put the stuff that's so hard to figure out!  I still don't know where everything goes, and I know just enough to help out with my specific situation.

    There are certain expenses where you are forced to use the "Accrual" accounting instead of "Cash."  That is, if a certain asset you buy has a useful life over several years, then you need to stretch that expense over the useful life.  This includes computers, software, cars (if you buy a car specifically for business transportation), houses, offices, etc.  In my case, I have two types of expenses I can claim:
    #1) A computer which is used 10% of the time for the writing business.
    #2) Computer software bought this year used 100% for the writing business.

    Let's see how I fill out this form.
    Part I) Section 179.  This is a special exception that allows you to claim the full amount of the expense during this year.  If you skip down to line 11 and 12, you'll see that no business income means you can't claim Section 179.  That describes me, so I leave this section blank.

    Also, the website I mention above advises against using Section 179, as you're probably better off deferring the deduction to later years when you start making a bigger profit.  In other words, if you claim 179 now when you're not making as much, you may end up paying more self-employment taxes later when you have bigger profits.

    Part II) The IRS instructions say that computer software (not claimed under Section 179) goes into line #16 using 3-year straight line depreciation.  This means you simply take how much you paid for software this year and divide by three.  You also claim this the next year and the next.  If I were to buy more software in 2011, then I would keep track of everything in a spreadsheet.

    Part III) I don't have anything that falls under MACRS Depreciation.  (Run for the hills!)

    Part IV) This adds everything up, including Part V which we've haven't gotten to yet.  Really, IRS, have you ever heard of linear processing?  I hope you guys never write a sci-fi novel!

    Part V) The IRS instructions define what's included in "Listed Property".  This includes the computer I mentioned above.  Note that I could have claimed Section 179 on the computer and the software, if I had a profit and if I chose to do so.  Since I didn't use Section 179, the computer has to go here in Part V.

    Since I only use that computer 10% for writing, I must put it in line #27.  Here's what I put in each column:
    a) Computer
    b) Date when I started using it for writing
    c) 10% business use
    d) the full price of the computer
    e) 0.10 * the full price of the computer (yes, I only get to deduct a tenth of the price - bummer!  I could tell the kids, "Sorry, no more computer for you.  You didn't eat your broccoli."  Hmmm....)
    f) recovery period = 5 years (always use this for computers)
    g) S/L for straight line depreciation
    h) divide (e) by (f).

    I get to include this over the next four years as well.  Note that I can change the % for business in later years (especially if the kids don't eat their broccoli).

    I left Section B blank, as that info is contained on Schedule C and I only have the one car I use for writing business.

    Part VI) I left this blank.  This appears to be for something else - one of those sections where you'll know if you have to fill it out.  The examples I've seen have all left that section blank.

    Okay, there you have it.  If you've gotten this far, then I'm a better writer than I thought.  Who else could captivate an audience who hopefully never has to fill out any of these forms?

    And if you have to fill one of these out yourself, happy tax filing!