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Behavioral Finance in Social Security

November 17, 2010 Leave a comment

We want freedom from the fear of poverty, yet we also want hope for riches. Government provides the first in Social Security and the second in lotteries. Social Security benefits alleviate some of our fear of poverty, and lottery tickets carry some hope for riches.

The Deficit Panel, chaired by Erskine Bowles and Alan Simpson, made several recommendations for reducing our mushrooming deficits, including revisions of Social Security. The Panel’s recommendations will be hotly debated in the months ahead, and the idea of privatizing Social Security will surely come up. Some will argue, as has been argued before, that Social Security should be structured in the image of IRA or 401(k) accounts, a voluntary program where people can deposit whatever Social Security money they wish during their working years and live on whatever that money yields in their retirement years. They will also argue that people should have the freedom to invest their Social Security money in anything they wish, whether Treasury bonds, stocks, real estate or gold.

Social Security can be structured to alleviate fear of poverty or promote hope for riches, yet it is structured to alleviate fear of poverty. Social Security can be structured as a voluntary program or a mandatory program, yet it is structured as a mandatory program. Social Security can be structured with private accounts or a national account, yet it is structured with a national account. Social Security can let people to choose their investments yet it allows only an annuity with monthly payments terminating when people and their dependents die.

President Franklin D. Roosevelt explained his rationale for Social Security when he introduced it. He said: “We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life, but we have tried to frame a law which will give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age.”

It is evident from President Roosevelt’s words that Social Security was designed from the outset to alleviate fear of poverty rather than promote hope for riches. It is also evident that it was designed as an insurance program rather than a savings program or pension plan. The rich need little protection against “poverty- ridden old age,” but the poor need it. This implies that Social Security was implicitly designed to “spread the wealth,” where the poor are likely to receive more, relative to their payments, than the rich. Moreover, the structure of Social Security is implicitly designed to counter behavioral deficiencies reflected in cognitive errors and insufficient self control.

Young people with sufficient self control find it easy to buy private insurance similar to that of Social Security at a price which might not exceed the price they now pay for Social Security. But young people with insufficient self control might be tempted to forego such insurance. Moreover, people afflicted by cognitive errors might invest Social Security unwisely. Insufficient self control and cognitive errors might consigns people to poverty-ridden old age
It is good to pause from time to time and reevaluate programs, such as Social Security, set decades ago. The deficit accompanying our crisis compels us into such reevaluation. We should consider the rationale for Social Security and its advantages and drawbacks before we proceed to revise it.